An interest rate collar is a specialized option that can be used to hedge against shifts in the interest rate. It provides a barrier for traders who utilize them by providing a ceiling for rising rates and a floor for declining rates.
When creating an interest rate collar, a trader purchases an interest rate cap and sells an interest rate floor. The premium on the options is designed to match the floor so that it ends up being a net zero cost collar option.
Interest rate collars are a unique instrument and option that can help secure cash flows and create peace of mind when taking out large quantities of debt with unsecured interest rates.
An interest rate collar is a specialized option that can be used to hedge against shifts in the interest rate.
Interest rate collars help to minimize risk and establish a maximum interest rate the borrower will pay (strike price of the option) with a caveat of agreeing to pay a minimum rate.
There are three possible outcomes when utilizing interest rate collars, 1) the face value of debt interest rate is paid 2) bank compensates the borrower if rates lift above the ceiling, and 3) the borrower compensates the bank if the rate falls below the floor.
Interest Rate Collars in Action
Let’s pretend for a second that you are the controller of a medium-sized company of 500 employees. Your company is seeking to take on some long-term debt in order to prime itself for expansion but wishes to mitigate and control its downside risk. You propose the utilization of an interest rate collar in order to better forecast cash flows and mitigate risk. You present the below possible outcomes to your board:
The above scenarios demonstrate to the board how your company can mitigate risk while paying upfront to purchase options that hedge your borrowing position. Purchasing such options will create a larger up-front cost but will better protect your company against fluctuations in the market.
Why Use Interest Rate Collars?
Interest rate collars help to minimize risk and establish a maximum interest rate the borrower will pay (strike price of the option) with a caveat of agreeing to pay a minimum rate. The rate will float between these two values throughout the existence of the position.
Companies and individuals that are wary of debt obligations may choose to utilize interest rate collars in order to better forecast interest rate payments and not find themselves on the wrong end of an interest rate position.
Disadvantages of Interest Rate Collars
One perceived disadvantage of purchasing an interest rate collar is if situation 1 outlined above occurs and the interest rate stays below the ceiling, but above the floor, the purchaser may feel that the collar provided no value and was an unnecessary expense.
It would be prudent to look at the purchase as an insurance policy, securing the downside risk in the event that market forces cause interest rates to skyrocket and create a potentially perilous situation for the borrower.
A more effective way of looking at it is to view it as the borrower benefiting from a maximum rate of interest and feeling secure that their risk has been minimized. These types of options can also be bought and structured in such a way that there is no upfront cost, and these costs can be spread over the duration of the instrument ownership.
CFI offers the Certified Banking & Credit Analyst (CBCA)® certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:
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