Interest Rate Collar
Buying an interest rate cap and selling an interest rate floor on the same rate, maturity and notional — capping borrowing cost from above while giving up the benefit of rates falling below the floor.
In plain language
A cap protects a borrower from rising rates, but it costs a premium. A collar pays for some or all of that premium by giving something away.
The workbook's definition: a derivative contract where a market participant simultaneously purchases an interest rate cap and sells an interest rate floor on the same interest rate for the same maturity and notional principal amount.
The result is a band. Above the cap strike, the cap pays the borrower. Below the floor strike, the borrower pays the floor buyer. Between the two, nothing changes hands and the borrower simply pays the floating rate. His effective borrowing cost is fenced between the two strikes.
Its mirror, the reverse interest rate collar, buys the floor and sells the cap — the band for someone who earns a floating rate rather than pays one.
How it works
| Interest rate collar | Reverse interest rate collar | |
|---|---|---|
| Cap | Bought | Sold |
| Floor | Sold | Bought |
| Protects against | Rising rates | Falling rates |
| Gives up | Benefit of rates below the floor strike | Benefit of rates above the cap strike |
| Condition | Same interest rate, maturity and notional principal on both legs | Same |
The premium arithmetic. The collar buyer pays the cap premium and receives the floor premium, so the net premium is lower than for a cap alone. Where the two premiums are equal, the collar costs nothing upfront; the price has been paid in the protection given away below the floor.
The pay-offs each period, from the definitions of the two legs:
Rate above cap strike → cap pays the collar holder
Rate between the strikes → nothing
Rate below floor strike → collar holder pays on the floor it sold
Where it trades. Collars and reverse collars are listed with caps and floors among OTC interest rate options in the workbook — customisable, negotiated, and exposed to the counterparty.
The same idea inside a bond. Chapter 1 describes a floating rate bond that carries both a cap to protect the issuer and a floor to protect the investor — and calls that bond a "Collar". Seen from the issuer's side, it is the same shape: protection above, a concession below.
Do not confuse any of this with the equity options collar, which is built from options on a stock rather than caps and floors on an interest rate.
The formula
For each period, on notional N and period fraction m/12:
Cap leg (bought) = + N × max(r − K_cap, 0) × m/12
Floor leg (sold) = − N × max(K_floor − r, 0) × m/12
Net collar pay-off = Cap leg + Floor leg
Net premium = Cap premium paid − Floor premium received
Effective borrowing rate (before premium) stays within [K_floor, K_cap]
A worked example
Illustrative numbers. The premiums are assumed.
A company pays a floating rate on a Rs 50 crore loan reset quarterly. A cap at 7 percent would cost Rs 15,00,000. It sells a floor at 5.50 percent on the same benchmark, maturity and notional for Rs 9,00,000.
Net premium = 15,00,000 − 9,00,000 = Rs 6,00,000
Three possible quarters:
| Benchmark | Cap leg | Floor leg | Net | Effective rate before premium |
|---|---|---|---|---|
| 8.00% | +50 cr × 1.00% × 3/12 = +Rs 12,50,000 | 0 | +Rs 12,50,000 | 7.00% |
| 6.00% | 0 | 0 | 0 | 6.00% |
| 5.00% | 0 | −50 cr × 0.50% × 3/12 = −Rs 6,25,000 | −Rs 6,25,000 | 5.50% |
In the 8 percent quarter the cap refunds everything above 7 percent. In the 5 percent quarter the loan itself becomes cheaper — but the company owes the floor buyer the gap down to 5.50 percent, so it never enjoys a rate below that.
The company has traded Rs 9,00,000 of premium for the right to benefit from rates below 5.50 percent. Whether that was a good trade depends on where rates go — which is the point of fixing a band rather than a single number.
Why NISM asks about it
Chapter 2 (Interest Rate Derivatives), section 2.2.3, defines the interest rate collar and the reverse interest rate collar immediately after the cap and floor, with the condition that both legs share the same rate, maturity and notional principal. Chapter 4 lists collars and reverse collars among OTC interest rate options. Expect a question that describes one combination — buy cap, sell floor — and asks for its name.
Common exam traps
- Collar = buy cap + sell floor. Reverse collar = buy floor + sell cap. This pairing is the whole question.
- Both legs must be on the same interest rate, same maturity and same notional principal.
- The floor sold reduces the net premium; it does not make the cap stronger.
- Below the floor strike the collar holder pays. Falling rates are no longer entirely good news.
- Collars are OTC interest rate options, not exchange traded.
- An FRB with both a cap (protecting the issuer) and a floor (protecting the investor) is also called a collar in Chapter 1.
- An equity options collar is a different strategy on a different underlying.
Check yourself
1.An Interest Rate Cap is best described as which of the following?
- a)A series of interest rate call options in which the buyer receives a payment at the end of each period when the underlying rate is above the strike rate
- b)A series of interest rate put options in which the buyer receives a payment when the underlying rate is below the strike rate
- c)The simultaneous purchase of a floor and sale of a cap on the same rate, maturity and notional
- d)A single option on an interest rate swap giving the right to receive fixed and pay floating
Show the answer
Answer: (a) A series of interest rate call options in which the buyer receives a payment at the end of each period when the underlying rate is above the strike rate
An Interest Rate Cap is a series of interest rate CALL options (called caplets) in which the buyer of the option receives a payment at the end of each period when the underlying interest rate is ABOVE a rate agreed in advance (the strike rate). It is the natural protection for a floating-rate borrower.
Option (b) is the Interest Rate Floor — a series of put options paying when the rate is below strike, used by holders of floating-rate assets. Option (c) is a Reverse Interest Rate Collar (buy floor, sell cap); an ordinary Collar is buy cap, sell floor. Option (d) is a call swaption, giving the holder the right to act as a "receiver" of fixed.
Where this is taught
Free preparation for NISM Series IVRelated terms
- CollarAn options strategy extending a covered call: hold the stock, sell a call above the price and buy a put below it, putting a floor under losses in exchange for a lower cap on profits.
- Interest Rate CapA series of interest rate call options, called caplets, that pays the buyer at the end of each period in which the underlying interest rate is above the strike rate agreed in advance.
- Interest Rate FloorA series of interest rate put options that pays the buyer at the end of each period in which the underlying interest rate is below the strike rate — protection against falling rates.
- Reverse Interest Rate CollarBuying an interest rate floor and selling an interest rate cap on the same rate, maturity and notional — protecting a floating-rate receiver against falling rates while giving up gains above the cap.
- SwaptionAn option on a swap — the right, not the obligation, to enter an interest rate swap at a predetermined strike rate on a future date, bought for a premium.
- OTC derivativeA non-standard derivative contract settled directly between counterparties on mutually agreed terms, relying on trust between them rather than on an exchange and clearing house.