How Interest Rate Collars Work?
An interest rate collar (or floor ceiling) is an agreement where the seller or provider of the collar agrees to limit the borrower’s floating interest rate exposure to a specified ceiling rate and floor rate. Analytically, this represents the simultaneous purchase of a cap(which is a series of put options)with the sale of a floor (which is a series of call options)
If market rates exceed the ceiling rate, then the collar provider will make payments to the buyer sufficient enough to bring its rate back to the ceiling. If rates fall below the floor, then the borrower makes payments to the collar provider to bring its rate back to the floor. When rates are between the floor and the ceiling the borrower pays the market rate of interest. The buyer of a collar has effectively confined his borrowing range.
The idea behind a collar is to lower the up-front payment associated with a cap purchase.
A floor rate is usually chosen so that the income derived from the sale equals the payment required for a cap purchase. This results in a zero cost collar.
The credit risk differs from traditional caps and floors because if Libor falls below the corporate counter party, payment must be made to the lender.
The following data graphically depicts an interest rate collar