Interest Rate Collar

Interest Rate Collar
See also

According to The Dictionary of Financial Risk Management it is „ a combination of an interest rate cap and interest rate floor. The buyer of the collar purchases the cap option to limit the maximum interest rate he will pay, and sells the floor option to obtain a premium to pay for the cap. The effect of the combination is to confine interest rate payments to a range bounded by the strike prices of the cap and floor options" [1].

Advantages and disadvantages of interest rate collar

Advantages [2], [3]:

  1. If financial institution plans to hedge against perspective of rising interest rates, it can obtain an interest rate collar. The hedge is connected to the interest rate cap, that generates payments to the institution in case of an increase in interest rates above the level agreed in contract.
  2. The benefit of interest rate collar is that term of collar is adjustable and can be custom-made to harmonize with the term of underlying liability to be secured.
  3. The amount of premium depends on the actual interest reference rate and its variation. For that reason, investor is able to set the cap and floor strike rates to reduce overall premium, or reduce its amount to zero.

Disadvantages[4]:

  1. In case of decreasing in rates below agreed in contract floor rate financial institution is forced to make payments to the counterparty.
  2. Resignation from the collar over the period of its lifetime is associated with termination fees according to the current market rates.
  3. The investor will be all the same vulnerable at interest rate movement, when the term of underlying liability is longer than that of the collar.

Reverse collars

An interest rate reverse collar coincides with the collar described above. The difference is that the buyer purchase the floor and simultaneously sells cup. That kind of derivative agreement is commonly used in view of its protection against falling interest rates. When the rate grows above the cap strike, the buyer is forced to pay for the discrepancy of the cap strike and floating rate. Nevertheless, in case of declining of floating rates below the floor exercice price, the buyer takes possession of the difference between the floor exercise price and floating rate. The amount of collar premium is contingent on market's estimation whether the rates will increase above the cap or go below the floor [5].

Trade life cycle for interest rate collar

R. Venkata Subramani indicates the following stages of an interest rate collar trade life cycle [6]:

  • Recording the trade- contingent
  • Account for the premium if any on the trade
  • Receive/pay the premium for the trade
  • Reset the interest rate for the ensuing period
  • Account for accrued interest if any on valuation date
  • Reverse the accrued interest if any on coupon date
  • Ascertain and account for the fair value on valuation date
  • Pay/receive interest on the pay date
  • Termination of the trade and accounting for termination fee
  • Payment or receipt of termination fee
  • Maturity of the trade
  • Reversal of the contingent entry on termination or maturity
  • FX revaluation entries (for foreign currency trades)
  • FX translation entries (for foreign currency trades)

Footnotes

  1. Gary L. Gastineau, Mark P. Kritzman (1992), The Dictionary of Financial Risk Management, s. 175
  2. Madura J. (2012), Financial Markets and Institutions, 10th Edition
  3. R. Venkata Subramani (2011), Accounting for Investments, Fixed Income Securities and Interest Rate Derivatives: A Practitioner's Guide (Volume 2), s. 564
  4. R. Venkata Subramani (2011), Accounting for Investments, Fixed Income Securities and Interest Rate Derivatives: A Practitioner's Guide (Volume 2), s. 564
  5. R. Venkata Subramani (2011), Accounting for Investments, Fixed Income Securities and Interest Rate Derivatives: A Practitioner's Guide (Volume 2), s. 275, 276
  6. R. Venkata Subramani (2011), Accounting for Investments, volume2 Fixed Income Securities and Interest Rate Derivatives: A Practitioner's Guide (Volume 2), volume 2, s. 565

References

Author: Faustyna Nowicka