Interest rate collars are done by buying an interest rate cap and selling an interest rate floor. The purchase of a cap sets a maximum interest rate that a borrower would have to pay if the reference rate rises. The sale of a floor sets the minimum interest rate that a borrower can benefit from if the reference rate declines.
Consider the following collar created by a borrower: a cap purchased with a strike price of 7% and a floor sold with a strike rate of 4%. If the reference rate exceeds 7%, the borrower receives a payment (I got that); if the reference rate is less than 4%, the borrower makes a payment (got that).
Thus, the borrower’s cost will have a range from 4% to 7%
I font quite get this. If interest rates drop to say 0, the cost to the borrower will be 4% (difference between the floor rat and actual rate). If it increases to say 2%, the borrower will lose 2%. If it goes up to 4%, the borrower till be at breakeveen (exercise equals actual).
Why does it then say that the cost will have a range from 4% to 7%?