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1) An interest rate Cap is where an option is used to set maximum interest rate for borrowers. If actual interest rate is lower, the option is allowed to lapse.
2) An interest rate Floor is where an option is used to set minimum interest rate for investors. If actual interest rate is higher, the option is allowed to lapse.
3) An interest rate Collar is where an option is used to set both maximum and minimum interest rate on borrowing and depositing.
“A borrower would buy a CAP to set maximum interest rate being paid on borrowings and sell a FLOOR. If interest rate fall then it would get no benefit from the CAP but would make a premium from selling a FLOOR.
However, a depositer would do the opposite.”
Could you correct me if anywhere wrong! And please explain me the last paragraph in quotation.
What you have written is correct.
A depositor wants to limit the minimum interest rate and so would buy a floor. If they created a collar then they would buy a floor and sell a cap (which would limit the maximum rate).
(It is very unlikely that you would be tested on collars in Paper FM. It is in Paper AFM that they get asked (along with calculations, and you cannot be asked for calculation on interest rate risk in Paper FM))
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