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
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’.