Interest Rate Collar

An interest rate collar is a combination of an interest rate cap and an interest rate floor. The buyer of the collar purchases the cap that places a ceiling on the interest rate he will pay, and sells the floor to obtain a premium to pay for all or part of the cap. The collar transaction limits interest rate payments by the buyer of the collar to a range bounded by the strike rates of the cap and floor. If the floating rate rises above the cap strike, the collar contract provides for payments from the seller of the collar to the buyer for the difference between the floating rate and the cap strike. If the floating rate falls below the floor strike, the collar buyer pays the collar seller the difference between the floor strike and the floating rate.
The collar premium charged by the seller depends upon the market's assessment of the probability that rates will move through the cap or floor level over the time horizon of the transaction. In other words, if the yield curve is upward sloping, a shorter term (two years vs. five years) and/or a higher cap strike (7.0% vs. 6.0%) or a higher floor strike (5.0% vs. 4.0%) will result in a lower collar premium. Normally, the collar premium for the entire life of the collar transaction is paid two days after the trade date. The collar premium takes the form of an up front premium that is usually expressed in basis points as a percentage of the notional principal amount. Many collar buyers purchase zero cost or zero premium collars. In a zero cost collar, the price paid for the cap equals the price received for the floor, and no net premium is exchanged.
Parties to an interest rate collar take on potential credit exposure to one another. The collar buyer is exposed to the seller for payments over the cap strike. The collar seller is exposed to the buyer for payments under the floor strike. At the Bank formal credit approval is required before entering into a collar transaction.
EXAMPLES OF PAYMENT FLOWS If cap strike > market rate > floor strike, there is no payment on either the cap or the floor. If market rate > cap strike, the seller of collar (seller of cap) pays the buyer (buyer of cap): notional principal x (floating rate - cap strike) x actual days/360 If market rate notional principal x (floor strike - floating rate) x actual days/360
TYPICAL CHARACTERISTICS

Start date: Spot or forward
Indexes: All Major Fixed Income Indexes
Term: Up to 10 years
Structures: Bullet, Amortizing or Accreting
Strike(s): Constant or at varying Levels

Reset Frequency: Semi-annually, Quarterly, Monthly, or Daily
Setting: Discreet or Average

TYPICAL CAP APPLICATION
Liability Management

Situation 1: The borrower is willing to give up protection, but wants to minimize the cost. The borrower is willing to give up some of the benefit of a decline in rates for cheaper cost protection against rising rates.
Solution: The borrower purchases an interest rate collar (buys the cap and sells the floor). Buying the cap provides protection from rising rates and selling the floor cheapens the cost of purchasing the cap. However, selling the floor requires the borrower to give up some of the benefit of a decline in rates.

Asset Management

Situation 1: An investor holding a floating rate note feels floating interest rates will remain unchanged or decline and wants to enhance the yield on the note.
Solution: The investor sells an interest rate collar (sells the cap and buys the floor). The investor collects the collar premium and benefits if rates drop below the floor level. However, if floating rates rise through the cap level the investor's yield will decline.