Reverse Interest Rate Collar

An interest rate collar is built for a borrower: buy a cap, sell a floor, and the borrowing cost is fenced inside a band. But a lender — someone who receives a floating rate rather than pays one — needs the fence built the other way round.

The workbook's definition: "A Reverse Interest Rate Collar is a derivative contract which involves simultaneous purchase of an interest rate floor and sale of an interest rate cap on the same interest rate for the same maturity and notional principal amount."

Buy the floor, sell the cap. The floor protects the floating-rate receiver if rates fall too far; the cap sold pays for some or all of that protection, at the cost of giving up the benefit if rates rise very high.

The premium arithmetic runs in the receiver's favour. The reverse collar holder receives the cap premium (having sold it) and pays the floor premium (having bought it). Where the two are equal, the position costs nothing upfront — the price is paid instead in the return given away above the cap strike.

The pay-offs each period:

Rate above cap strike      -> reverse collar holder pays on the cap it sold
Rate between the strikes   -> nothing; holder simply earns the floating rate
Rate below floor strike    -> the floor bought pays the holder

Where it trades. Like the collar itself, the reverse collar is listed among OTC interest rate options in the workbook — negotiated, customisable, and carrying counterparty exposure, not exchange traded.

For each period, on notional N and period fraction m/12:

  Floor leg (bought)    = + N x max(K_floor - r, 0) x m/12
  Cap leg (sold)        = - N x max(r - K_cap, 0)   x m/12

  Net collar pay-off    = Floor leg + Cap leg
  Net premium           = Cap premium received - Floor premium paid

Effective receiving rate (before premium) stays within [K_floor, K_cap]

Illustrative numbers, in the shape of the workbook's own collar example. The premiums are assumed.

An insurer holds a Rs 30 crore floating-rate investment, resetting quarterly, and is worried a falling-rate cycle will cut its income. It buys a floor at 5.50 percent for Rs 8,00,000, and sells a cap at 8.00 percent on the same benchmark, maturity and notional, receiving Rs 6,50,000.

Net premium paid = 8,00,000 - 6,50,000 = Rs 1,50,000

Three possible quarters:

In the 5 percent quarter the floor tops the insurer's income back up to 5.50 percent. In the 8.60 percent quarter the investment itself pays more — but the insurer owes the cap buyer the excess above 8.00 percent, so it never actually earns more than the cap strike.

The insurer paid a net Rs 1,50,000 for the certainty that its income never falls below 5.50 percent — in exchange for giving up everything above 8.00 percent. Whether that traded was worth it depends on where rates actually go, exactly as with the collar itself.

Chapter 2 (Interest Rate Derivatives), section 2.2.3, defines the reverse interest rate collar in the same clause as the collar, immediately after cap and floor. Chapter 4 lists collars and reverse collars together among OTC interest rate options. Expect a question that describes buy-floor-sell-cap and asks for the name, or one that gives a collar's construction and asks for its mirror.

• Reverse collar = buy floor + sell cap. Collar = buy cap + sell floor. Getting the two swapped is the entire trap.
• A reverse collar is built for a floating-rate receiver, not a payer — it protects income from falling, not borrowing cost from rising.
• Both legs must share the same interest rate, maturity and notional principal, exactly as for the ordinary collar.
• Above the cap strike, the reverse collar holder pays — a rising benchmark is no longer entirely good news once the position is on.
• Like the collar, the reverse collar trades OTC, not on an exchange.
• Do not confuse this with an ordinary short collar or an equity options collar — this instrument is built entirely from interest rate caps and floors.