interest rate collar

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vitamin

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The book said "a borrower with a floating rate loan may buy a cap for protection against rates above the cap and sell a floor in order to defray some of the cost of the cap."

I don't understand the part of "sell a floor in order to defray some of the cost of the cap". Could someone pls explain?

why does a borrower want to engage in both cap and floor at the same time?


thanks!!
 
He would rather continue owning the floor (so if interest rates dropped really low he would profit), but the book is saying that he can give up this upside for some downside protection.
 
Buying a cap means that the company would to pay for the collar, but he will recieve the premium for the floor, that would offset the cost of the cap. Also if the borrower anticipated that rates may remain fixed or not dip too much or may appreciate, it may be a good way to defray the cost of the cap.



Edited 1 time(s). Last edit at Friday, May 5, 2006 at 06:19PM by jamespucyk.
 
he is getting cash for the floor tht he sells ..kinda of like an option writer because he recieves a premium ...and he pays for the cap ...therfore he gets an inflow of funds from selling the floor and has an outflow when he buys / pays for the cap ...
hence recovering some of the cost of the cap ...
 
but if the borrower sells a floor, he will have to pay if rate falls below the floor. that means even though the premium he received would kind of offset the cost he paid for the cap, that's not a "guarantee"?

thanks again!
 
your right, but if the rates fall, he will make money in the first transaction. (floating rate borrower), so his overall return would be positive. (if he chooses the right interest rate for the floor)
 
Also just to note if an issuer is concerned about rates perhaps going up and has it on good advice that they probibly will (i.e. if the economy goes through a long expansion that will last the life of a bond), then rates dropping will be seen, probibly, as a non-reality and hence a safe gamble to reduce the overall price of the transaction.
 
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