AFM
Interest Rate Collars
This is a short article to explain what an interest rate collar is, and how interest rate options may be used to create one.
If we are borrowing money, then we can fix a maximum interest rate by buying a put option.
So, for example, if we buy a put option at a strike price of 92.00 then we will be fixing a maximum interest rate of 8%.
So….if the actual interest rate turns out to be only 5% we do not exercise the option and we just pay 5%. But if the actual interest rate turns out to be 10% then we pay the interest at 10% but exercise the option and effectively ‘claim back’ 2% from the seller of the option. (For details of how exactly this works see the Course Notes and lectures on options).
The benefit of buying the option is obvious - we fix a maximum rate but we get the benefit if rates are lower. However the downside is that we have to pay a premium for the option - whether or not we end up exercising it.
Similarly, there are people who are depositing money and therefore will be wanting to fix a minimum interest rate. They will buy a call option. If the interest rate falls then they will ‘claim’ from the seller of the option, but if the interest rate rises then they will get the benefit of the higher rates and will not exercise the option.
Back to the borrower!
They fix a maximum rate, but the downside is they have to pay the premium.
What they can do to reduce the cost is to also sell a call option (effectively becoming a dealer) and will therefore receive a premium from the person buying it.
This means they still have the benefit of fixing a maximum rate (a ‘cap’) but the net cost of it is reduced because although they still pay the premium for the put option, they will also be receiving a premium from selling the call option.
However, selling a call option will mean that they are accepting a minimum interest rate (a ‘floor’).
To illustrate with a very simple example.
Suppose we buy a put option with a strike price of 92.00 (fixing a maximum interest rate of 8%).
Suppose we also sell a call option with a strike price of 96.00 (fixing a minimum interest rate for the buyer of 4%).
Let us see what happens for different actual interest rates that might apply when they actually start
the loan.
Suppose the actual interest rate turns out to be:
10%; b) 6%; and c) 3%
a) If the actual interest is 10% then we will ‘claim’ on the put option and get 2% back from the seller. The person who bought the call option will not ‘claim’ because they are getting higher interest on their deposit. So the net cost to us is 8% - this is the most we will ever end up paying.
b) If the actual interest is 6% then we will not ‘claim’ on the put option. Also the person who bought the call option will not ‘claim’ from us. So we will end up paying 6% - we have got the benefit of the lower rate.
c) If the actual interest is 3% then we will not ‘claim’ on the put option. However, the person who bought the call option from us (because they wanted to fix a minimum interest rate on their deposit of 4%) will ‘claim’ 1% on us because we sold it to them. So we will end up paying 4% in total (3% on the loan, and 1% to the buyer of the call option).
The end result means that whatever the interest rate turns out to be, the maximum that we will end up paying will be 8% (fixed by buying the put option of 92.00), but it will also mean that the minimum we will end up paying is 4% (fixed by selling the call option at 96.00).
The reason that we might wish to do this is that we are still able to fix the maximum interest we will pay, but by accepting a minimum interest the net cost of the premium will be reduced (we pay for the put option, but receive a premium from selling the call option).
Having a maximum rate is a ‘cap’. Having a minimum rate is a ‘floor’.
Having a maximum and a minimum is a ‘collar’.
if its net premium payable or receivable as
in buy put sell call?
I really wouldn't have been able to manage without you. You are amazing.
You set the standard very high for teaching.
Thanks Sir you are amazing!
Thanks.
And secondly, if there happens to the same number of contacts, we can calculate a "net" premium to save time?
Many thanks!
Thanks for your detailed explanation about Interest Rate collars. But one thing confuse me a lot is that I also find that the strategy of simultaneously buying a put and selling a call actually leads to unlimited gains and unlimited loss. So why doesn't it happen to the Interest Rate collars? Could you please help me with it? Thanks a lot!
Greenie
Because the options are the right to buy a sell futures, then if you are a borrower then buying a put will limit the maximum interest rate. If that was all you did then there would be no limit on the minimum. However by selling a call you are limiting the minimum interest rate. As explained, the only reason for doing this is to save money on the net premium.
Thanks a lot OT..
Thanks in advance !
Like for put option, we have to do -strike-premium to get net of premium, so the lowest net of will be chosen for a put righ? Cuz we r borrowing so we want to pay least??? Plz help me
If you read carefully what I have written you will see that the way a collar is created is to buy a put option and sell a call option at the same time.
I also write that the reason for doing it is to minimise the net premium cost - we pay a premium for buying a put option and receive a premium from selling a call option!
As to deciding when to exercise an option or not, and how we calculate the effect, have you watched the free lectures on interest rate options?
what will happen in this case:
a) actual rate 10%. i will exercise my put option and get 2% back. the holder of the call will not exercise since he is also getting more than 8%. i have paid only 8%, which is what i wanted and i reduce my premium costs too.
b) 6%: i will not exercise my put option and just pay 6%. the holder, will exercise since he wants 8%. so i will pay 2% to him and my total payment is 8%
c) 3%. i will not exercise my put and pay 3%. but the holder of the call will exercise and i will pay him 8-3=5%. which brings my payment rate to 8%
d) 1%. i will not exercise my put and pay 1%. the holder of the call will exercise and i pay him 8-1=7%. my effective rate is again 8%.
so setting up a cap/floor of 8%, i have essentially fixed my rate at 8% and as far as the premiums go, would they not net out to zero? (i dont know how the premiums behave tho)
The net premium is very unlikely to be zero. Just suppose that the current interest rate is 10%, and you use a cap and a floor to fix a rate at only 5%. You will not be able to do that for nothing - there will be a big net premium to pay :-)
god bless
When you mention in point a) that we can claim back the 2%. Aren't we actually making a profit from the futures deal, ie: a reduction in futures price and not the difference of 2%, between the (put) futures price and the market rate (ie 10%).
Im a little confused now, a collar relates to interest rate options does it not? and not interest rate futures?
As far as i understand you claim back from the futures dealer in a futures deal, but you make a profit through an option deal by buying a future at the updated futures rate and exercising the option to sell....no?
Thank you
In the exam, when you are given multiple strike prices, which one do you select to cap your interest and which one do you select for the collar?
If you are short of time, then just creating one collar in the exam will get more than half the marks because what matters is that you can prove that you know what a collar is.
For borrower (line X 90.00;92.00;95.000)
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\
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Is an upper line a floor (sell call) and a lower line a cap (buy put)? To fix a maximum interest rate I must buy a put option so it must be a lower line. Am I right ?
For lender
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/
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Is an upper line a cap (sell put) and a lower line a floor (buy call)?
However, whether you are a borrower or a lender, a cap is the higher rate and a floor is the lower rate.
(But you certainly will not be asked to draw a graph in the exam :-) )
Thanks for your article I have read it and things are now becoming clear. However I still need some clarifications. Can these terms be used inter changeably
Buy put option and Buy a cap
Buy a call option and Buy a Floor
regards
I do suggest that you watch the free lectures on interest rate risk.
I pray to ALLAH for lengthening your life and grant you success in all your works. And that you continue and keep up with this great work.
I can't believe I'm reading this article right now! Collars was giving me a headache and now after the exam just going through the article, it makes just soo much sense.
My biggest regret while studying towards my acca is that i never watched the open tuition lecture videos. !
You guy's make so much sense and the concepts get so much clearer.
But my greatest happiness is watching ur videos on p4 ! Esp on risk managt. (Y)
Thank you.
Keep up the fantastic work, as you really are gifted.
Thanks for the simplified collar article,is it possible that you cant do another one on interest rate swaps before the december 2015 exam? I will greatly appreciate.
The buyer will not exercise, but if we are the seller (we have sold a call option) then it is the buyer that will decide not to exercise (which is what the examiner has said "the call option is not exercised")
If the futures price is higher than the exercise price then the buyer will exercise.
Therefore the effect of selling a call option is to limit the minimum interest.
(It will help you to watch all of the lectures on interest rate options - collars are just one example of how options can be used)
5% is equivalent to a futures price of 95.
6% is equivalent to 94 (not 96!).
The buyer of the call option has the right to exercise the option and buy futures at 94. If the price of the future is 96, then he will exercise the option and buy futures at 94 and immediately sell at 96 and make a profit. So the buyer would exercise the option.
the market interest rate is at transaction date is 4.4% and the put options interest rate is 4.5% (100-95.5). So if we excercise it we will be making a loss of 0.1% right. But still the examiner has excersiced it, why has he don't it.
Ask in the Ask the Tutor Forum (not as a comment on an article) and say which question you mean.
Now getting a limelight, rushing to your lecture sir, thanks for simplified illustration.
past exams papers from December 2012 called Global December 2012 question
What does mean Global?
should I do practice them as well if I try only not Global?
and why it is no pilot papers?
If you are taking the Global variant of the P4 exam then you should practice those questions - Global is the exam in all countries except those that have their own special exam.
Yes there are pilot papers - they are called specimen papers.
Just seeing this after the exam yesterday. I attempted the interest rate options question but left out the collar part. One thing that confused me though was the ticks given. I remember in one of your lectures you state that you usually ignore ticks. I answered the questions they was you solve them but inadvertently multiplied the ticks per contract again. Is that a problem - would the examiner ignore this error of judgement? How many marks can one get for correctly getting the number of contracts and the basis & expected futures price?
Thanks.
However most of the marks are for proving you understand (rather than getting the exact figures) and so assuming your workings were clear enough I would not think that you would lose very many marks.
Don't worry about it now - I am sure it will not be many marks lost :-)
I really want to appreciate your revision of the December 2013 Q1. It really made a difference as Q1 this diet was a prototype.
GOD bless you.
Although it has to be said that the variables that are included in Q1 need to be reassessed as students cant really finish such questions in the alloted time frame.
Regards,
Can I clarify this please, I am little bit confused.
ACCA Dec 2011 , Question 2. Alecto Co. (To Borrow a Loan)
Current LIBOR 3.3%
Using Strike Price (Put option) 96.00
Using Strike Price (Call Option Sold) 96.50
DATE OF TRANSACTION (EXPECTED OUTCOME) - Using Interest Rate decrease
Interest Rate (LIBOR) decreased by 0.5% , so LIBOR becomes 2.8%
Of Course LIBOR has gone below our 'CAP' of 4% (Strike of 96.00) , so Don't exercise option. At the same time LIBOR has also gone below minimum interest receivable on Call (of 3.5%), So they need to claim back difference between 3.5% and 2.8% - We will pay them this difference. Translated to futures, this will be difference between 96.50 (call Strike) and 97.20 (LIBOR on date of Loan).
BUT the examiner Solution was :
Difference Between the Strike Price of Call Options sold 96.50 (3.5%) and 97.02 (2.98%), which was the futures prices estimated on the date of Loan (May 1). This has confused me .
I have gone through your explanation on Collars here again and the example you provided, so I think my solution above should be correct?
Please let me know.
Thanks
It may help to watch my lecture on interest rate options. (It's not in itself a collar problem - it's they way that interest rate options always work)
Many Thanks
One final thing please;
CASE 1
(As a borrower and assuming Interest rate goes up on date of loan)
Effective Interest paid will be ?
Net Premium paid (Difference btw Put premium and Call premium)
Add Whatever the Interest is on the date of transaction
Less Profit on Put Option
That will then be used to determine the effective Interest rate.
CASE 2
(As a borrower and assuming Interest rate went down on date of loan)
Effective Interest paid will be ?
Net Premium paid (Difference btw Put premium and Call premium)
Add Whatever the Interest is on the date of transaction
Add what the call option buyer claims from us (assuming interest was lower than call option rate)
That will then be used to determine the effective Interest rate.
Hope this is correct?
Thanks
Would be great if you explain that floor part again. Thx
First, that we are borrowing money and so the interest we way on the borrowing will be whatever the rate turns out to be.
Secondly, by selling a call option, we are being the dealer and if interest rates drop below the strike then we will have to pay out to the person who bought it.
So....suppose we sold a call option at a strike of 95 (which is equivalent to 5%).
If interest rates fall to 4% the we will pay 4% on the borrowing. But the person who bought the call option will 'claim' from us 1% (5% strike - 4%). So we will end up effectively paying out 4% + 1% = 5%.
If interest falls to 3% then we will pay 3% on the borrowing. But the person who bought the call option will claim from is 2% (5% strike - 3%). So we will end up effectively paying out 3% + 2% = 5%
So whatever happens, we will always end up paying out at least 5% - it cannot end up being any lower. So we have fixed a 'floor' - a minimum rate.
(If interest rates are 6%, then we pay 6% on the borrowing but the person who bought the call option will not claim from us, so we then pay 6%. We limit the maximum we pay by buying a put option, but that is a separate thing and I think you are happy with that side of it.)
From the above explanation, it becomes evident that there is sort of contractual agreement that makes it imperative to pay the buyer of the call option when the interest rate falls below the exercise price.
Please advise if there is a rational explanation to this obligation to reimburse the call option buyer. It seems that there is something more to this than a simple contractual obligation.
Please elaborate.
Thank you
If I sell you a call option then you have the right to buy from me an interest rate future at a fixed price. If you choose to exercise that right then I have to sell you the future at a fixed price.
If you are asking for a different reason, then please ask in the Ask the Tutor Forum (not under an article on collars).
The calculation of the premiums is no different to how the y are calculated in my existing lectures on options.