Interest Rate Collar

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.

Next:

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%?

If interest rates drop below 4%, you pay the market rate on your loan, and you pay the difference between 4% and the market rate on your floor: the net is that you pay 4%. (For example, if market rates dropped to 3%, you would pay 3% on your loan, and 4% – 3% = 1% on the floor: a total of 4%.)

If interest rates rise above 7%, you pay the market rate on your loan, and you receive the difference between the market rate and 7% on your cap: the net is that you pay 7%. (For example, if market rates rose to 9%, you would pay 9% on your loan, and receive 9% – 7% = 2% on your cap: a net of 7%.)

You flatter me.

You’re quite welcome.

It is also worth noting that companies usually buy the cap at the same price as the sale of floor, making it a “zero cost collar”.

But the payoff is as S2000 said above.

how does it work for reverse collars? So going with the same example, purchase floor 4%, sell cap 7%: if market rates drop to 3%, you pay 3% on the loan and 1% on the floor. net = 4%.

if market rates rise to 8%, you pay 8% on the loan and 1% on the cap, BUT where is the offset to make this a net 7%?

Reverse collars are for lenders, not for borrowers.

You buy the 4% floor; if rates drop to 3% you get 3% on the loan and you get 1% on the floor: 4% total.

You sell the cap at 7%; if rates rise to 8% you get 8% on the loan and pay 1% on the cap: 7% net.

This isn’t quite right, in the reverse collar the long floor will receive payments and short cap will make payments. And the intent is to protect the lender, as opposed to borrower.

So take the example from the magician and imagine it from the other side (i.e. lender and collar seller).

EDIT: posted at same time! I’m referring to franks post.

Thanks, ro!

I read your post (pre-edit) and thought I was losing my mind, which, apart from assuming facts not in evidence, wasn’t altogether surprising. You’ve restored my faith in something. I forget what.

Got it now. Thanks.

My pleasure.

Thank you magician. I was having difficulty with this part

You’re quite welcome.

if we continue in the above eg and take exercise price of cap and floor at lets say 6%.

if the reference rate goes above 6%, say 8% the borrower pays the market rate =8% and receives 2%, whereas if the ref rate goes below 6%, say 2% the borrower pays the market rate = 2% and an additional difference of 6%-2% i.e 4%.

his net payment comes out to be 2%. Have I got this right? How is this transaction making a zero cost dollar?

This isn’t a collar. In essence, it’s a plain vanilla interest rate swap: receive the (floating) market rate and pay (the fixed rate of) 6%.

No, it comes out to 6% (pay 2% on the loan and pay 4% on the floor). You’ve locked in a fixed rate of 6%.

It probably isn’t. Unless the fixed rate on a (market) swap is 6%, this won’t be zero cost.

got it thanks @S2000magician

My pleasure.