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For understanding collar hedge, for now, FORGET interest rate options and interest futures. Just keep in mind the simple good old put and call option. If basic understanding of how it works is clear, you can do the complicated stuff easily.
I can’t count the many times the textbook’s explanation has confused me. So instead of just repeating that, I’ve created an example, with dialogues and everything. It may seem silly, but atleast give it a shot, you have nothing to lose.
XY is a person who wants to buy a horse in 3 months time. So he goes to a guy named HG to buy a 3-month call option on the animal.
XY: Beautiful horses.
HG: Thanks
XY: I would like to buy one.
HG: Alright.
XY: After 3 months.
HG: Oh….
XY: So if you’ll be kind enough to sell me a three month call option.
HG: Why?
XY: Prices could rise. I want to protect myself against that. If I buy a call option now on the horse at an exercise price of let’s say $500, I’ll be able to buy the horse at $500 in 3 months time, instead of the prevailing market rate that time.
HG: And you’ll use your call option when the market price is above the exercise price. Let’s say at $650. So you can pay $150 less.
XY: Obviously.
HG: But if the market price is below your option’s exercise price, then you won’t use the option. You’ll just buy at whatever the market price is.
XY: Yes.
HG: So avoid the bad and take benefit from the good. A win-win situation for you, huh?
XY: Yup.
HG (smirking evilly): Want to hear how much premium I’ll be charging for selling you the option to make that wonderful win-win situation happen?
XY is shocked after HG whispers the premium cost.
XY: T-That’s too much!
HG: What do you expect? Higher the benefit you get, higher the cost you have to pay.
XY: There must be something! Something to reduce the premium!
HG: Hmm……yes there is, infact. You’re already buying a call option from me right?
XY: Depends you lower the premium!
HG: Just listen. Buy a call from me and sell a put option to me at the same time. But sell the put at a lower exercise price than the call. Let’s say if call’s exercise price is $500 then put could be at an exercise price of $200.
XY: What good will that do?
HG: Well….you’ll still be able to avoid a price increase….buy horse at $500 if the market price is higher and take advantage of a price decrease in case market price falls below $500…..but not all price decreases.
XY: What do you mean?
HG: Well, if market price falls to $450….or $350 or even $220—the range between $500 and $200—you can take advantage of that. But if the market price goes below $200, I will exercise the put option you sold me.
XY: So?
HG: So if the market price of a horse is let’s say $150 in 3 month’s time, and I use my option, you’ll have to buy the horse from me at $200 instead. By selling a put option to me, you’ve given me the right to sell the horse at a fixed price of $200 to you. And you’ve got an obligation to buy it from me at $200.
XY isn’t happy at the news.
HG: Cheer up. You may have to pay premium on call, but you’ll receive premium on put. That way your net premium cost will be decreased. Isn’t that what you wanted? A lower premium cost? Just keep praying the market price doesn’t fall below the put exercise price of $200.
XY is still very unhappy.
HG: Hey! What do you expect! If you want a lower premium cost, you’ll get your benefits lowered too!
If only our textbooks could be so entertaining 🙂
Anyways, when XY buys the call option, he’s doing the normal hedge where he’s afraid the price of the asset he needs to buy in the future would rise so he fixes the price now by purchasing an option. But since prices could also fall, he doesn’t want to get stuck paying a fixed price and wants access to the benefits of a lower market price.
But when he sells a put option at the same time, he kind of restricts access to some of the benefits. He created a collar hedge.
Now collar hedge has a max and min limit.
Maximum limit: Technically when money is leaving your pocket you would want to set a maximum limit, like ‘I can’t afford to pay more than $500 for a horse’. By purchasing the call option with an exercise price of $500, that’s what you’re doing, setting a maximum limit for yourself.
Minimum limit: ‘I swear I won’t spend less than $200 on a horse’. This is what you’re doing by selling a put option. Setting a minimum rate of money you’ll spend on a horse. Well kind of forced to set a minimum limit on yourself, but atleast by doing this the premium cost is reduced.
So I can’t afford to pay $500 for a horse, but I also can’t spend less than $200 on it.
Now if you were selling horse instead of buying, your thoughts would be: ‘I don’t want to receive less than $200 when I sell my precious horse’. So you set a minimum limit by BUYING a put option with an exercise price of $200. Now since you’re buying, you’ll have to pay the premium.
Now again you’re unhappy about the high premium cost. You want to reduce it so you create a collar hedge by SELLING a….a…..what? Call option ofcourse! And you’ll receive premium on it. The call’s exercise price should be higher than your put’s exercise price, let’s suppose $500. This will set a maximum limit or in other words: ‘I swear I won’t sell my horse for more than $500 🙁
So by creating a collar what you’re doing is: “I don’t want to receive less than $200 when I sell my precious horse, but I also swear not to sell my horse for more than $500.” And this is all for the sake of reducing the expensive cost of the option.
And that was the BASIC idea. Very long but I really hope things got clear.
Now if you’re clear on which options we BUY when we want to borrow/lend money, you can create a collar hedge by selling the opposite options at the same time.(If we’re buying puts then sell calls, and vice versa)
When money is leaving your pocket, or in other words when you’re paying interest, you’re setting a maximum interest rate you can afford to pay by buying a put option(Caps) from bank.
To create a collar hedge, you sell a call option(floor) to the bank to set a minimum interest rate.
So we have:
“I won’t pay interest more than 12% if interest rates increase, but I also can’t pay less than 8% if interest rates decrease.”
Again I know there are more complications when it comes to interest rate hedges, but I hope the basic concept of how a collar hedge works is somewhat clear.
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cyma,
What a funny and easy understanding explanation and it make me clear.
Tks for the effort
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You’re welcome 🙂
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very good explanation…so how does a collar differ from a cap
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I hope this info will help clear more things about caps, floors and collars—from basics to what we get in exam. Had an XY goes to the bank script planned but didn’t get time to type it 🙁
Call options on interest rates are known as Caps.
Just like you want to buy horse in 3 months time, and you’re worried horse prices will increase, you go buy a call option.
Similarly, if you want to borrow money(or for the sake of understanding, buy money) in three months time, and you’re worried the money’s price, which is known as interest rate, will rise, you go to the bank and buy a call option, but it’s called buying an interest rate cap instead or simply buying a cap.
Now that would make put options on interest rates known as floors. And when do you normally buy put options? When you’re selling something in a few months time and are afraid prices will decrease of thing you’re going to sell.
Similarly, if you’re going to invest money(or for the sake of understanding, sell money) in a few month’s time, you’re worried about a decline in interest rates, so you buy a put option from the bank, but we call it buying a floor instead.
Now as usual, premium cost will make these wonderful caps and floors really expensive. So you create collar hedge.
How do you normally create a collar hedge for something you’re buying? You buy call at a higher exercise price and sell put at a lower exercise price. Now translated into interest rate’s language, it would be buying caps with a higher interest rate and selling floors with a lower interest.(This would be for borrowing)
Buying floors with lower interest rate and selling caps at a higher interest rate will be for investing.
Now the thing about P4 is….we’re not given call options and put options on interest rates. Because it would make things easy and simple for us, and we really can’t have that in P4;) So things need to be complicated.
So we get call and put options on….interest rate futures instead yes, interest rate futures and not interest rates themselves. So it’s kind of like saying “Oh sorry, options on horses aren’t available, but we do have on cute white fluffy bunnies. You can use those to hedge.”
Ok maybe not bunnies but anything whose price moves opposite to horse prices. That’s how interest rate and interest rate futures prices move. When one goes up, the other goes down and vice versa. So now what happens?
Put options on interest rate futures are known as caps. Earlier it was call options on interest rates, just interest rates, which were known as caps. So when you buy put options, you’re buying caps. And you buy caps when you’re borrowing.
Call options on interest rate futures are known as floors. We buy floors when we’re going to invest money.
So the buying caps and floors is the same as before for borrowing and investing. The difference is caps are now known as puts and floors are known as calls.
So to create a collar hedge you would now be doing……………….well the same thing except the options will be different.
For borrowing:
Buy caps(put options) at a higher interest rate and sell floors(call options) at lower interest rate.
For investing:
Buy floor(call options) at a lower interest rate and sell caps(put options) at a higher interest rate.
Now the interest rate futures exercise prices will be quoted like 9330 or 9550 so convert them into interest rates and you’ll get 6.7% and 4.5%. These will enable you to easily create a collar hedge than wondering for minutes whether to use the exercise price of 9330 or 9550 as the higher or the lower interest rate.
Hope this helps a bit 🙂
Cyma! Thanks a lot for spending your time explaining this! Really great help!!! 🙂
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hello,
could you please forward me the interim, Final and Mock examination for P4 at carmen.egnanfin@gh.nestle.com ? Both Kaplan and BPP.
thakx
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awesome….thank you a loooottttt….love you dearrrr….
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awesome….thank you a loooottttt….love you dearrrr….
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thank you so much. u r a life saver 🙂
GREAT explaantion! very simple. U need to write ACCA books instead of BPP and Kaplan. 🙂
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