Interest Rate Collar

Interest Rate Collar: Definition and How It Works

An interest rate collar is a derivatives-based hedging strategy that limits a party’s exposure to interest rate movements by establishing both a ceiling (cap) and a floor on interest costs or receipts. It is commonly used by variable-rate borrowers to protect against rising rates while accepting a minimum effective rate, or by lenders in the reverse form to protect against falling rates.

Key points

• A collar combines buying an interest rate cap and selling an interest rate floor on the same reference index, notional amount, and maturity.
• The premium received from selling the floor offsets (partially or fully) the cost of buying the cap, making the hedge relatively low cost.
• The collar protects against adverse rate moves but limits upside from favorable moves (i.e., it creates a band of effective interest rates).

Caps and Floors — the building blocks

• Interest rate cap: A cap is a series of call options on a floating-rate index (commonly 3- or 6-month LIBOR or its replacements). If the reference rate exceeds the cap strike at a reset date, the cap buyer receives a payment equal to the excess, reducing the buyer’s effective interest cost. The cap establishes a maximum payable rate.
• Interest rate floor: A floor is a series of put options on the same floating-rate index. If the reference rate falls below the floor strike at a reset date, the floor buyer receives a payment, establishing a minimum effective rate for the recipient of the floor payments.

How a collar works (borrower example)

1. The borrower buys an interest rate cap with a chosen strike (the collar ceiling).
2. Simultaneously, the borrower sells an interest rate floor with a lower strike (the collar floor).
3. The premium received for selling the floor offsets the cost of the cap.

Result: The borrower’s net interest exposure is effectively confined between the floor and the cap. If rates rise above the cap, the cap pays and offsets higher borrowing costs. If rates fall below the floor, the borrower (as floor seller) must pay, so they do not benefit below the floor level.

Example: Buy a cap at 10% and sell a floor at 8%.
* If the reference rate > 10%: the cap pays the collar holder, offsetting higher interest.
* If the reference rate < 8%: the floor buyer receives payments funded by the floor seller (the collar holder), so the collar holder’s effective rate doesn’t fall below about 8%.
* Between 8% and 10%: no option payments; the borrower experiences the floating rate as usual.

Reverse interest rate collar

A reverse collar is used to protect a lender (or someone receiving floating payments) from falling rates. It is the mirror image:
* Long (buy) an interest rate floor and short (sell) an interest rate cap.
* Premium from selling the cap offsets the cost of buying the floor.
* The long floor pays when rates fall below the floor strike; the short cap pays when rates rise above the cap strike.

Advantages and disadvantages

Advantages:
* Cost-effective hedge because selling one option helps finance the other.
* Provides a clear band of protection and predictability for budgeting interest expense or income.

Disadvantages:
* Limits benefit from favorable rate moves (for a borrower, rates falling below the floor).
* Counterparty risk and fees still apply; collars must be sized and timed to match underlying exposures.

Common uses

• Variable-rate borrowers hedging against rising interest costs while keeping some flexibility.
• Bond holders or institutions hedging interest-rate exposure on floating-rate instruments.
• Lenders using reverse collars to preserve minimum interest income.

An interest rate collar is a practical tool for controlling interest-rate risk when a party is willing to trade some potential benefit for lower hedging cost and defined protection.