ishwar_jindal
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- Dec 31, 2015
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As per section 5.C in reading 51 of CFAI Level 2 2016 book the borrower can indulge in creating a interest rate collar and below is given as their rationale.
This is done by buying an interest rate cap and selling an interest rate floor. The purchase of the cap sets a maximum interest rate that a borrower would have to pay if the reference rate rises. The sale of a floor sets the minimum interest rate that a borrower can benefit from if the reference rate declines. Therefore, there is a range for the interest rate that the borrower must pay if the reference rate changes
For example, consider the following collar created by a borrower: a cap purchased with a strike rate of 7% and a floor sold with a strike rate of 4%. If the reference rate exceeds 7%, the borrower receives a payment; if the reference rate is less than 4%, the borrower makes a payment. Thus, the borrower’s cost will have a range from 4% to 7%
I presume the borrower has taken a loan on floating rate and hence her most concerning area should be increase in floating rate on the loan because this would increase her payment cost. So in that sense purchasing/buying a cap make sense but why would a borrower would be selling interest rate floor? Shouldn’t borrower leave the downward movement of interest rate unhedge as it will only benefit her. As in this example, limiting the payment upto 7% is good strategy but then why to still pay at least 4% when interest rate decline (and goes below 4%)??
This is done by buying an interest rate cap and selling an interest rate floor. The purchase of the cap sets a maximum interest rate that a borrower would have to pay if the reference rate rises. The sale of a floor sets the minimum interest rate that a borrower can benefit from if the reference rate declines. Therefore, there is a range for the interest rate that the borrower must pay if the reference rate changes
For example, consider the following collar created by a borrower: a cap purchased with a strike rate of 7% and a floor sold with a strike rate of 4%. If the reference rate exceeds 7%, the borrower receives a payment; if the reference rate is less than 4%, the borrower makes a payment. Thus, the borrower’s cost will have a range from 4% to 7%
I presume the borrower has taken a loan on floating rate and hence her most concerning area should be increase in floating rate on the loan because this would increase her payment cost. So in that sense purchasing/buying a cap make sense but why would a borrower would be selling interest rate floor? Shouldn’t borrower leave the downward movement of interest rate unhedge as it will only benefit her. As in this example, limiting the payment upto 7% is good strategy but then why to still pay at least 4% when interest rate decline (and goes below 4%)??