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’.
This explanation is very clear. I now understand what the collar is about. Thanks Mr. Moffat
You are welcome 🙂
the way you are explaining is totally different
i didn’t understood the logic of collar hedge. i had a look at examiner answer what he was doing buy a put option at which interest rate is maximum and then comparing it to future price of the options to know whether to exercise or not the option and also selling a call option at the same time and also comparing it to the future prices to determine whether or not to excercise the option he was calculating the difference between these both to calculate the gain on options and also he was netting off the the premium payable for both options. i did not understand why he was buying a put option and selling a call option at a same time. whats the reason behind doing so
The way I explain it is not completely different at all!! You clearly have not read it carefully enough.
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?
Very easy to understand. Thanks alot.
Thank you for the comment 🙂
Just to play with setting up with collars … lets say that i am a super duper treasurer, thinking i will set up a collar with cap and floor at 8%
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)
You can use a cap and a floor to effectively fix a rate, just as you suggest.
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 🙂
thank u sir….i cd never think i wd be able to understand swaps..but thanks to u… i do
god bless
Thank you for the comment 🙂
Hello
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
Thank you very much for simplifying the concept.
thanks
You are welcome 🙂
Thank you Sir this article was very straightforward and helpful
You are welcome 🙂
Hello John
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?
Ideally you should look at all the combinations – there is no such thing as a ‘best’ collar because a lower net premium means having a smaller collar (and therefore losing more of the benefit of the interest rate moving in our favour, and vice versa).
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.
Everything is clear except presenting collars on a graph. I cannot atache a file so I try to type it 🙂
For borrower (line X 90.00;92.00;95.000)
——-
\
——-
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
——-
/
—–
Is an upper line a cap (sell put) and a lower line a floor (buy call)?
I can’t really answer properly because I cannot see the graph.
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 🙂 )
John Moffat
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
No – it all depends on whether you are depositing money or borrowing money.
I do suggest that you watch the free lectures on interest rate risk.
Sir John Moffat.
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.
Thank you very much for your comments 🙂
understood. thanks very much.
You are welcome 🙂
Thank you 😀 Great article
Thank you for the comment 🙂
a big applauds to you sir,,,, i just got this cleared from my head,,,, thanks a lot and god bless
thanks. Great little article. clarified the issue for me instantly.
Well explained,wow!
Thank you 🙂
Fantastic Lecturer and Teacher , it took me 6 months to get to grips with this cap,floor ,collars topic ; but having read through your example within the space of 5 minutes I am relieved to say I now understand.
Keep up the fantastic work, as you really are gifted.
Thanks a lot for your comment – I am pleased that the example has helped you 🙂
You are welcome 🙂