What is an Interest Rate Collar? How Does an Interest Rate Cap Work?

Interest collars limit the losses due to an adverse movement in interest rate for an underlying asset such as a bond. Collars also restrict the maximum gains due to favorable interest rate movements, though.

Interest rate caps are upper limits of an interest rate options contract. In contrast, floors are the minimum interest rate limits of the options contract.

What is an Interest Rate Collar?

Interest rate collars are specialized options strategies. A collar involves holding an asset for a specific period and protecting the investment through a protective put and a short call option at the same time.

The put option and call option must be carried out for the same period and the same expiry dates. Interest rate collars work best for borrowers when using floating rate borrowing instruments. Collars protect borrowers against uncertain interest rate movements.

Creditors can also use it to limit losses due to lower interest rates and maximize benefits if the interest rates rise.

How Does an Interest Rate Collar Work?

When you hedge with an interest collar, you create a protective position through buying a put and selling a call option simultaneously. Premium received from a call option will equal the premium paid for the put option. Both option contracts would be set for the same expiration date and similar notional amounts.

These instruments are effective tools for hedging against interest rate risks. Investors can use collars for mitigating the rising or declining interest rates with investments in bonds. Similarly, borrowers can use interest rate options and collars to mitigate rising interest rate costs. Lenders (banks) also use collars to reduce their risk of lowering interest rates.

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Example

Let’s consider a simple example to understand the working of interest rate collars.

Suppose a company ABC borrows from a bank XYZ and enters into an interest rate options contract. Say, the company ABC sets the cap at 8% and floor at 5%.

Now there can be three possible scenarios of interest rate changes.

Scenario 1:

The interest rate remains between the cap and floor limits. The company ABC makes interest payments at the actual interest rate. There are no losses or profits in this scenario.

Scenario 2:

The actual interest rate rises above the cap rate. The company ABC makes payment at the actual rate but gets compensated for the difference between the actual rate and cap rate.

Scenario 3:

The actual interest rate falls below the floor rate. The company ABC makes payment at the floor rate and compensates the bank XYZ for the difference between the actual rate and the floor rate.

We can see that using an interest rate collar protects the company from rising interest rate costs. At the same time, it would sacrifice additional gains if interest rates were to fall below the floor rates.

What is an Interest Rate Cap?

An Interest Cap is an upper limit on how high interest can go in a variable interest rate instrument. It is used in interest rate collars and options contracts. It is usually used in variable interest rate instruments such as AMRs.

Borrowers are at a maximum risk when interest rates are predicted to rise. An interest rate cap is a useful instrument that can protect borrowers against rising interest rates.

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Interest rate caps can be structured in various forms as agreed by the lenders and borrowers. A common cap contract would limit the upper limit of interest rate. Say, the current interest rate is 5% and the cap is set for a 5-year variable loan with a cap of 8%. It means even if the interest rate rises above 8%, the borrower would pay only 8%.

Another common form of caps is to structure incremental interest rate rises. This structure is common with adjustable mortgage rate contracts. Say, a 2-2-5 cap agreement is agreed upon. It means the first increment with the AMR would be up to a maximum of 2% from the initial rate. The second increment would be another 2% increment when the AMR shifts to the variable interest annually.

Finally, the last digit indicates that the AMR rate can increase up to only 5% additional on the base rate. For instance, the AMR started with a 3% rate; it can go up to 8% with a 2-2-5 cap contract.

Pros and Cons of Interest Rate Collars and Caps

These instruments can minimize the borrowing costs of individuals and corporate borrowers. Collars are particularly useful in a low-interest-rate environment when interest rates are bound to increase in the future.

A downside of the collars is the potential loss of opportunity costs if the interest rates fall further. Thus, borrowers must rely on solid forecasting techniques to predict interest rate movements.

Interest rate Caps offer protection through a maximum upper limit on the interest rate. Caps are useful in variable interest rate instruments such as AMRs and floating-rate bank loans.

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The risk of using caps is also the potential opportunity cost if the interest rates fall further.

Final Thoughts

Interest rate collars and caps are useful instruments that protect borrowers from rising interest rate costs. The risks with these instruments are the foregoing benefits in case the interest rates fall further.

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