Collar


The collar is the combination of a cap with a floor and can be used either for hedging an investment or loan.

One conceivable use is the limitation of interest rate risk of a floating rate loan (e.g. 3-M Euribor). In this case, the customer enters into a cap agreement and thereby secures a maximum interest rate. Depending on the customer’s market view it’s possible to sell a floor and thereby reduce the premium. Participation in falling money market rates is thus limited to the agreed interest rate floor (= interest rate corridor).

  • Maximum interest rate = Cap strike
  • Minimum interest rate = Floor strike

Example:

Underlying transaction: Floating rate loan

Collar

Interest rate hedge transaction collar
Agreed maximum interest of 3% (Cap) and minimum interest 1.50% (Floor)

Collar

 

Collar

Please click on the picture for a larger image

 

The collar agreement can be customized to meet your needs and those of the underlying transaction:

  • Maximum and minimum interest rate (strike rate)
  • Notional and currency
  • Term
  • Reference Rate
  • Amortizing Structure
  • Roll-Over Dates

In the event of early termination, the collar can be sold in the market at the current market value. A negative market value can result for the writer of the floor option.