Interest Rate Collar

Definition

A security which combines the purchase of a cap and the sale of a floor to specify a range in
which an interest rate will fluctuate. The security insulates the buyer against the risk of a
significant rise in a floating rate, but limits the benefits of a drop in that floating rate.

An interest rate collar can be an effective way of hedging interest rate risk associated with
holding bonds. Since a bond's price falls when interest rates go up, the interest rate cap can
guarantee a maximum decline in the bond's value. While interest rate floor does limit the
potential appreciation of a bond given a decrease in rates, it provides upfront cash to help pay for
the cost of the ceiling.

Let's say an investor enters a collar by purchasing a ceiling with a rate of 10% and sells a floor at
8%. Whenever the interest rate is above 10%, the investor will receive a payment from whoever
sold the ceiling. If the interest rate drops to 7%, which is under the floor, the investor must now
make a payment to the party that bought the floor.

What Is an Interest Rate Collar?

An interest rate collar is a type of strategy used in investing to hedge the exposure an investor
experiences in relation to fluctuations in interest rates. This is typically managed by using
derivatives to hedge that exposure, effectively containing or collaring that the investor’s
vulnerability to shifts in those interest rates. While an interest rate collar does have the effect of
limiting the interest rate the investor will pay, it also leaves the investor open to the chance for
additional profits if the interest rate should drop.

One type of investment opportunity that may be enhanced with the aid of an interest rate collar is
bond issues. This is because the price of a bond decreases when interest rates increase. By using
the collar to cap the decrease by setting a limit on the increase in interest rates, the investor is
able to minimize the potential for sustaining a loss. At the same time, the collar is also used to
create what is known as an interest rate floor. This is basically the rate of interest at which the
investor will sell. The designation of both an interest rate ceiling and floor serves to allow the
investor to project the anticipated return in both the worst case and best case scenarios. To a
degree, this helps to reduce the level of interest rate risk associated with the investment.

For example, an interest rate collar on a bond issue may establish an interest rate maximum or
ceiling of twelve percent, while identifying a floor of ten percent. Should the prevailing interest
rate rise above that ceiling, the investor receives a payment from whoever purchased that ceiling,
effectively offsetting the losses incurred due to the reduced value of the bond. At the same time,
should the interest rate fall below the floor level, the investor must make a payment to whoever
purchased that floor. That action offsets the profits the investor would otherwise earn from the
increased value of the bond.

1
CHARACTERISTICS

A Collar is the simultaneous purchase of a Cap and the sale of a Floor for the same expiration.

This is a common strategy for reducing the cost of the premium to insure against an adverse
movement in short term interest rates. The purchaser of the collar hedges against an upward
swing in interest rates but simultaneously relinquishes the right to benefit from any significant
fall in interest rates. Furthermore should rates fall below the level of the floor the purchaser is
obliged to pay the difference between the floor strike and the prevailing market rates. The
premium obtained from the sale of the floor will in most cases only partially offset the cost of the
cap. This cost can be reduced by raising the strike of the floor, when the premium of the floor
exactly matches that of the cap this is known as a Zero Cost Collar.

A zero cost collar with the same strike for the cap and floor is equivalent to an Interest Rate
Swap. The purchase of a cap and simultaneous sale of a floor converts floating rate debt to fixed
rate. The sale of a cap and purchase of a floor will convert fixed rate debt into floating..Arbitrage
or hedging between the two markets is possible but uncommon as many strikes are not well
supported and the option spreads are often wide. The collar strategy is more popular than the
corridor because market participants concerned over potential rate rises will be more willing to
sell a floor, which is unlikely to be exercised, to reduce their costs rather than sell another cap
with a higher strike.

An Interest Rate Collar sets a maximum (cap) and minimum (floor) boundary on a given floating
rate (such as LIBOR or Prime). If the floating rate rises above the cap level, the client is credited
for the difference. If the floating rate falls below the floor level, the client is debited for the
difference. Some collars can be transacted for little or no upfront fee. If terminated prior to
maturity, a collar may result in a gain or a loss for the client

Benefits

• The collar reduces the cost of interest-rate protection.

• The collar provides protection against higher interest rates.
• You can sell the collar back to us at any time.

2
The main disadvantage of a collar is that you have to pay a certain minimum rate of interest and
you lose some of the possible benefit of lower interest rates.

Features
• You can use a Collar for a loan you already have or a loan you are planning to take out in
the near future.
• We provide Interest-Rate Collars in major currencies.
• We can arrange different maturities normally up to five years.
• The premium you pay for an Interest-Rate Collar may be 'tax allowable' - check with
your tax advisers.
• If you have a zero-cost interest-rate collar, you do not have to pay any premiums at
inception.

EXAMPLE

Suppose a borrower just completed a mid-sized acquisition that will be financed with a
syndicated bank credit facility. The facility is a $250 million, 6 year combined reducing
revolving credit and term loan with grid based LIBOR pricing. The financing includes a 50%
hedge requirement for a minimum term of 3 years.

The borrower and its lenders have agreed that the maximum LIBOR rate threshold to
comfortably support cash flow projections is 7.50%. The company wants to minimize the upfront
cost associated with a hedge and also wants to retain some flexibility if LIBOR declines.

Management believes that 3-month LIBOR, currently at 6.50%, is headed higher over the
foreseeable future but may eventually reverse course.

Every 3 months, the debt will re-price based on the prevailing LIBOR rate. Simultaneously, any
payments due under the collar will be determined. If LIBOR has risen above 7.50%, the
borrower will be reimbursed for the difference.

For instance, if LIBOR is at 9.00%, the company will be credited for (9.00%-7.50%) = 1.50%. If
LIBOR has declined below 5.50% to, say 5.00%, the borrower will owe (5.50%-5.00%) = .50%
on the collar. If LIBOR is between 7.50% and 5.50%, no collar payments are due. In sum,
LIBOR can fluctuate no higher than 7.50% and no lower than 5.50% on 50% of the company's
debt over the next 3 years.