Interest Rate Collar

An interest rate collar is a powerful risk management technique investors employ to safeguard themselves against fluctuations in variable interest rates. This strategy involves utilizing financial derivatives, specifically, options contracts consisting of a cap and a floor, to establish a protective barrier against interest rate movements.

Like other risk hedging strategies, the collar enables investors to adopt opposing positions concurrently, potentially maximizing profits when their predictions align with market conditions while protecting in case the anticipated outcomes fail to materialize. This technique proves particularly effective within the bond market, offering investors a valuable tool for managing interest rate risk.

• An interest rate collar agreement can be defined as a strategy limiting investor losses from rising variable interest rates.
• It is a risk management technique where the investor establishes a cap or an upper limit and a floor or a lower limit. 
• Beyond these limits, any fluctuations in the interest rate will not affect the investor, thus minimizing their losses.
• Interest rate collars are designed to protect against interest rate volatility by setting upper and lower limits. This strategy allows investors to establish a predetermined range within which interest rate fluctuations will not impact their positions, reducing potential losses and enhancing risk management.

The interest rate collar strategy is a commonly used tool in the bond market as a low-cost risk management technique that offers the ability to secure minimum returns. The concept is straightforward: interest rates can move in two directions, either up or down. By placing bets in both directions, investors can mitigate potential losses. However, these bets are not random.

Suppose an investor anticipates that interest rates will rise based on factors such as the instrument's performance, company outlook, and market conditions. In this case, they would set a cap and sell a call option, predicting that the interest rate will increase but not exceed a certain limit. To safeguard against a decline in interest rates, they establish a floor and purchase a put option on the same date and index, predicting that the interest rate will fall but not below a specific threshold. The premium received from selling the call option covers the cost of purchasing the put option.

Let's delve into interest rate caps and floors in more detail. Caps determine the maximum level to which interest rates can rise, ensuring that the investor remains unaffected beyond this limit. Caps are a risk management strategy that can be established by selling a call option. On the other hand, interest rate floors protect against declining interest rates. They set the minimum level below which interest rates will not affect the investor. Floors can be set by purchasing a put option.

Interest rate collars are particularly relevant for bondholders who are more exposed to interest rate risks. A rise in interest rates can lead to a decline in asset value, making collars an attractive option to safeguard against such scenarios. Currency traders and homeowners purchasing through mortgages also find interest rate collars beneficial.

This concept is explained in the graph below. According to the graph, the buyer of the option can take advantage of the fluctuation in the interest rate and earn profit while also controlling the risk in the process. It is to be remembered that the strategy is quite expensive due to its flexibility. However, there is a limit to the advantage due to the cap set in both the cases, the call and put option.

In the diagram below, the approach is buying a put option and selling a call option, but strike price for both is different. For the floor, which is the call option, a limit is set. Similarly, the cap, which is a put option also has a limit. In case the interest rate falls below the floor, the counterparty will gain because the option holder does not have the right to take advantage of the fall beyond the floor. Same is the case with the cap for the put option. In this manner there is a maximum and a minimum limit up to which the interest rates can be received or paid.

Source

Let's look into the following examples to understand the concept.

Example #1

Let's consider Meredith, who purchased a house using a mortgage loan with variable interest rates averaging 5%. A year later, concerned about market volatility, she followed her friend's advice and implemented an interest rate collar for at least two years. Meredith establishes a cap of 6.5% and a floor of 4%. The cap ensures that she won't face excessively high-interest payments if rates rise, while the floor protects her from smaller installments that could extend the number of payments.

Example #2

The Federal Reserve's decisions on interest rates have a direct impact on bond prices and yields. When interest rates increase, bond prices typically decline while yields rise. Historically, the U.S. 10-year treasury notes have yielded higher returns compared to 3-month treasury bills. However, since 2022, the yield curve has become inverted, creating an unusual situation. Despite this, in October 2022, the 10-year treasury notes reached a peak yield of 4% and remained in the range of 3.3% to 4.1%.

Experienced investors in 10-year treasury notes can employ an interest rate collar to their advantage. Investors can set a cap and a floor by understanding the movement of interest rates and yields as the Federal Reserve adjusts rates to manage inflation. This strategy allows them to benefit from the high yield of the notes while protecting potential decreases in yield.

Let's compare the pros and cons of interest rate collars.

#1 – Pros

• The biggest advantage of any options collar is protection from risk. Hedging by taking opposite stands establishes an interest rate ceiling and floor beyond which the investor will not incur any losses. 
• It provides some control to investors as they can decide the upper and lower limits of the interest rate that will affect the risk they are exposed to.
• Since the put option can be purchased using the premium from the call option, the investor will incur low costs, if not zero costs.
• While bondholders are exposed to interest rate risk, they can receive minimum guaranteed returns from the options collar.

#2 – Cons

• The most serious downside to the collar strategy is the limited returns from the derivative contract. This is because of the cap and floor limits established by the investor. For instance, suppose the interest rate increased more than the investor predicted; they could not enjoy the full benefits.
• Also, if the investor's original prediction is accurate, there would be no point in the opposite stand the investor takes. It would be an unnecessary expenditure.
• While the collar is a zero-cost strategy, the investors still have to incur brokerage fees and commissions while buying the put and selling the call options.

Let us understand the differences between interest rate collar, swap and cap:

• An interest rate swap can be defined as a forward contract where payments based on interest rates are exchanged between two parties to the contract for a fixed period. 
• As the term suggests, parties swap or exchange their interest rates. Fixed and floating rates are mostly exchanged based on the conditions in the parties' respective markets.
• As mentioned, an interest rate cap is an upper limit on how high the interest rates of a particular instrument can rise. The investor establishes the ceiling and protects themselves from losses beyond that limit.
• Interest rate swaps, caps, and collars are all risk management strategies that investors use to minimize losses. 
• A collar is made up of a cap and a floor. While the cap sets the upper limit, the floor sets the lower limit, and the investor only worries about interest rate fluctuations in this range. Thus, a collar offers more protective coverage than a cap.
• Swaps concern specific interest rates at which they are exchanged, but collars specify a range.

This has been a guide to what is Interest Rate Collar. We explain its examples, compare it with swap and cap, and advantages, and disadvantages. You can learn more about it from the following articles –

• Floating Rate Note
• Interest Rate Derivatives
• Synthetic Position