Accounting for Investments, Volume 2: Fixed Income Securities and Interest Rate Derivatives—A Practitioner's Guide

SUMMARY

• An interest rate collar is an instrument that combines both a cap and a floor. The cap component of the instrument gives the investor protection against rising rates by guaranteeing that the investor will never pay above a pre-agreed rate.
• The floor component of the collar at the same time allows the investor to take advantage of the falling interest rates until the interest rate hits a predetermined rate, known as floor rate.
• A collar effectively creates an interest rate range with an upper and lower limit and depending upon where the cap and floor levels are set, will reduce or eliminate the requirement for a premium.
• An interest rate collar protects the investor against increases in interest rates beyond a predetermined level known as the cap rate, while still allowing the investor to take advantage of falling interest rates down to a predetermined level, known as the floor rate.
• The investor, however, is exposed to a further fall in the interest rates below the floor rate. In a nutshell, an interest rate collar is equivalent to that of buying a cap and selling a floor.
• Since an interest rate collar includes the buying of a cap instrument, all the benefits of a cap instrument are applicable for this instrument. Caps provide the entity with protection against unfavorable interest rate movements above the strike rate. Cap contracts are flexible as they are over-the-counter products and are customized to suit the requirements of the parties to the trade. The strike rate ...