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’.
Just came across this article. Very clear, well explained. Thank you John and all who posted questions.
Please Mr John, in a collar when do I know
if its net premium payable or receivable as
in buy put sell call?
You pay a premium on whichever option you are buying, and receive a premium on whichever option you are selling. The net premium is the difference between the two.
i wish my future is as clear as this article. thank you John!
Thank you for your comment 🙂
Thank you so much for what you do, John.
I really wouldn’t have been able to manage without you. You are amazing.
You set the standard very high for teaching.
Wow! The concept is amazingly explained, its so crystal clear to me.
Thanks Sir you are amazing!
Thank you for your comment 🙂
Thank you for this article. Made collar much clearer to me.
Thanks for the comment 🙂
This explanation is awesome
Thank you for your comment 🙂
Thanks
You are welcome 🙂
Sorry if I’ve missed this bit from your explanation. I understand that a borrower will buy a put option and simultaneously sell a call. Does it follow that an investor will buy a call option and sell a put?
Thanks.
Yes – that is correct 🙂
Thanks!
You are welcome 🙂
Would I be correct in saying, firstly, that the number of contacts for the cap and floor could differ, because of the differing option prices?
And secondly, if there happens to the same number of contacts, we can calculate a “net” premium to save time?
Many thanks!
I just had a think about it, and in fact the contract size will be the same for both the cap and the floor, won’t it?
Sorry, I meant number of contacts in my last post. Sorry about all the posts, I’m not sure how to edit on my mobile!
Yes – it would be the same number of contracts 🙂
Hi Sir,
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
No – interest rate collars are quite the reverse.
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.
I was worried about no lecture on interest rate collar,but this article is good as a lecture 🙂
Thanks a lot OT..
I am glad you found my article useful 🙂
Sir John, I have a query relating to the “The Armstrong Group” question which appeared in sept/dec 15 paper. The solution says we will buy december call at 97.00 and sell december put at 96.50 ( we are an investor in the question). I don’t understand the logic behind this. Wouldn’t it be more better in terms of risk if we buy cap of 3.5% atleast instead of 3.0% (we will earn extra 0.5% if interest rates fall) and sell floor of 3.0% to the option holder (we will save 0.5% if interest rates fall) ? Please help me understand the reasoning behind what the solution suggests. How do we even choose which rate to use for cap and floor option?
Thanks in advance !
See my answer to Zhi Yi, below. Different collars are available, but remember that the net cost will be different also (and the premium is payable whether or not the options end up being exercised).
Hi, how to determine which exercise price to enter to the options when buy call and sell put?
There are various collars available depending on what exercise prices are available in the question. There is no ‘best’ collar – it is up to the company to decide what ‘limits’ they want and the associated net cost. Your job in the exam is to prove you know what a collar is, and to discuss the choices.
Can u plz help me in choosing the right stike in case of options
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
See my previous reply – there is no best combination of strike prices.
Excellent!
Thank you for the comment 🙂
Thank you very much John, prior to your article the concept of combining a cap and a floor defied logic but now it all makes sense, thanks a million.
Thank you for the comment 🙂