interest rate collar

[RayJay]

Is the whole point of interest rate collars just hedging the premiums?
For example.
Rates are currently 6%.
You buy a cap w/ strike @ 8%
You sell a floor w/ strike @ 4%.
that’s a zero-cost collar?
But i’m also confused what if rates jumped to 10%. So you execute your cap so the value of that cap is (2% of notional amount). But how is selling that floor suppose to hedge? Cause if rates are now 10% the floor you sold is just more money to you. If Rates drop to 2% the buyer of the floor will execute you and will lose and the cap you have is worth 0.
Am I thinking about this all wrong?

 

[cpk123]

zero cost is because you paid a premium to buy the cap - which you offset by receiving premium for the floor. you pay nothing to enter into the collar. Both the Cap and the floor are on the same underlying rate (of 6%). The exercise rates on the cap and the floor adjust so that the premiums offset. They might not exactly end up being the 8% and 4% that you arrived at, just fyi.
A cap is bought by you (as a borrower) to reduce the rates of interest that you pay on the borrowing. If the rates go up to 10% - the 8% is the max that you would pay.
Say it goes to 10% rate. You pay 10%, but the Cap pays you back (10% - 8%) = 2% … ensuring you only paid 8%. (finally).
The 4% floor ensures that this would be the least you would pay. You cannot go below the 4%. If the rate falls to 3% e.g. you pay 3% on the notional. then the floor is exercised - and you pay 4% (Floor exercise) - 3% (LIBOR Rate) = 1% to the floor counterparty - and you net pay 4%.
The cap and the floor together ensure that your interest rate outflows are in the 4% to 10% range (both included).
HTH.

 

[S2000magician]

RayJay wrote:Is the whole point of interest rate collars just hedging the premiums?

Not exactly. The whole point is to buy the protection you want with zero out-of-pocket; you finance the protection you want by selling protection to someone else (at your peril).
We cannot tell if it’s a zero-cost collar because we don’t know the premia. If the premium on the floor is the same as the premium on the cap, then it’s zero-cost; otherwise, it’s not.

RayJay wrote:But i’m also confused what if rates jumped to 10%. So you execute your cap so the value of that cap is (2% of notional amount). But how is selling that floor suppose to hedge?

The proceeds from selling the floor cover the cost of the cap.

RayJay wrote:Cause if rates are now 10% the floor you sold is just more money to you. If Rates drop to 2% the buyer of the floor will execute you and will lose and the cap you have is worth 0.
Am I thinking about this all wrong?

Not all wrong. Only a little wrong.
You give up some gain when interest rates drop for protection when interest rates climb; that’s the cost of the protection.

 

[RayJay]

Ok thanks guys I think I have a better understanding now. I think the main issue was I was assuming you could predict if it would end up being a zero-cost .