why the zero cost collar?

CFA Level I Derivatives
#1

instead just enter into a FRA as the pay of will be the same whatever may be the outcome. is it because while entering a collar u have the liberty to choose different strike rates for the long call and short put?

#2

with a FRA or a future you are effectively fixing your rate, that is - even if it moves in your favour. A floor or cap would provide insurance against an adverse outcome, but comes at the cost of premium. Treasury or finance departments will always go for a zero cost collar because there is no capital outlay, (even though we know that with an uneven implied volatility skew the strikes they choose will be uneven distances from the underlying), which allows them to do their job and look good.

#3

to add to spahettios, when you enter into an FRA, it is exactly at the market forward rate, which locks you into this rate.

but if you use a collar, you can get 2 rates that are a band around the current market forward rate. What is appealing about this is for giving up some downside, you gain some upside when using a band.

for example, lets say I am a treasurer… and I need to borrow some cash in the future. I am therefore exposed to interest rate increases, and I therefore would like for interest rates to go down.

Out of the two choices I could, go to the FRA market and lock in my interest rate now, or… rather I could buy a interest rate call option and sell an interest rate put option at some levels above and below the market. on the call side, I am exposed to interest rates moving up to the call strike (generating a loss relative to where I could lock in at the FRA price), but on the put side, I can participate down to the put strike (generating a gain relative to where I could lock in at the FRA price).

#4

Hi

Think like that you are supposing that interest rate might will go down and you need to hedge of that. So the strategy you will follow is ,sell the cap and buy the floor.The premium amout will adjust = 0,Now It sounds like 0 cost collar.

#5

so guys its basically like it has the potential to enjoy a bit of upside while sacrifing a bit of downside?

#6

so guys its basically like it has the potential to enjoy a bit of upside while sacrifing a bit of downside?

#7

Yes it has the potential to enjoy a bit of upside while protecting a bit of downside.