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

MEANING OF INTEREST RATE COLLAR

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 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.

In other words, 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.

The term collar comes from the fact that the entity’s interest cost will never be lower than the floor level and will never be greater than the cap level. Interest rate collars are a popular way of managing the interest risk of any entity having a huge debt burden.

Benefits of an interest rate collar instrument

• Since an interest rate collar includes the buying of a cap instrument, ...