Firefox https://www.wallstreetmojo.

com/interest-rate-collar/

Home » Derivatives Resources » Interest Rate Collar

Interest Rate Collar

Article by Reviewed by
Wallstreetmojo Team Dheeraj Vaidya, CFA, FRM

What Is an Interest Rate Collar? 

An interest rate collar is a powerful risk management technique investors employ to
safeguard themselves against fluctuations in variable interest rates. This strategy
involves utilizing financial derivatives, specifically, options contracts consisting of a
cap and a floor, to establish a protective barrier against interest rate movements.

 You are free to use this image on your website, templaes, etc, Please provide us with an attribution link

Like other risk hedging strategies, the collar enables investors to adopt opposing
positions concurrently, potentially maximizing profits when their predictions align with
market conditions while protecting in case the anticipated outcomes fail to materialize.
This technique proves particularly effective within the bond market, offering investors
a valuable tool for managing interest rate risk.

Table of contents

• What Is an Interest Rate Collar? 

◦ How Does An Interest Rate Collar Work?

◦ Examples 

◦ Advantages And Disadvantages

◦ Interest Rate Collar vs Swap vs Cap

◦ Frequently Asked Questions (FAQs)

◦ Recommended Articles

1 of 8 18/6/2023, 2:49 pm
Firefox https://www.wallstreetmojo.com/interest-rate-collar/


Key Takeaways

• An interest rate collar agreement can be defined as a strategy limiting

investor losses from rising variable interest rates.

• It is a risk management technique where the investor establishes a cap or

an upper limit and a floor or a lower limit. 

• Beyond these limits, any fluctuations in the interest rate will not affect the
investor, thus minimizing their losses.

• Interest rate collars are designed to protect against interest rate volatility by
setting upper and lower limits. This strategy allows investors to establish a
predetermined range within which interest rate fluctuations will not impact
their positions, reducing potential losses and enhancing risk management.

How Does An Interest Rate Collar Work?

The interest rate collar strategy is a commonly used tool in the bond market as a low-
cost risk management technique that offers the ability to secure minimum returns.
The concept is straightforward: interest rates can move in two directions, either up or
down. By placing bets in both directions, investors can mitigate potential losses.
However, these bets are not random.

Suppose an investor anticipates that interest rates will rise based on factors such as the
instrument’s performance, company outlook, and market conditions. In this case, they
would set a cap and sell a call option, predicting that the interest rate will increase but
not exceed a certain limit. To safeguard against a decline in interest rates, they
establish a floor and purchase a put option on the same date and index, predicting
that the interest rate will fall but not below a specific threshold. The premium received
from selling the call option covers the cost of purchasing the put option.

Let’s delve into interest rate caps and floors in more detail. Caps determine the
maximum level to which interest rates can rise, ensuring that the investor remains
unaffected beyond this limit. Caps are a risk management strategy that can be
established by selling a call option. On the other hand, interest rate floors protect
against declining interest rates. They set the minimum level below which interest rates
will not affect the investor. Floors can be set by purchasing a put option.

Interest rate collars are particularly relevant for bondholders who are more exposed to
interest rate risks. A rise in interest rates can lead to a decline in asset value, making
collars an attractive option to safeguard against such scenarios. Currency traders and
homeowners purchasing through mortgages also find interest rate collars beneficial.

Examples 
Let’s look into the following examples to understand the concept.

2 of 8 18/6/2023, 2:49 pm
Firefox https://www.wallstreetmojo.com/interest-rate-collar/

Example #1

Let’s consider Meredith, who purchased a house using a mortgage loan with variable
interest rates averaging 5%. A year later, concerned about market volatility, she
followed her friend’s advice and implemented an interest rate collar for at least two
years. Meredith establishes a cap of 6.5% and a floor of 4%. The cap ensures that she
won’t face excessively high-interest payments if rates rise, while the floor protects her
from smaller installments that could extend the number of payments.

Example #2
The Federal Reserve’s decisions on interest rates have a direct impact on bond prices
and yields. When interest rates increase, bond prices typically decline while yields rise.
Historically, the U.S. 10-year treasury notes have yielded higher returns compared to
3-month treasury bills. However, since 2022, the yield curve has become inverted,
creating an unusual situation. Despite this, in October 2022, the 10-year treasury notes
reached a peak yield of 4% and remained in the range of 3.3% to 4.1%.

Experienced investors in 10-year treasury notes can employ an interest rate collar to
their advantage. Investors can set a cap and a floor by understanding the movement of
interest rates and yields as the Federal Reserve adjusts rates to manage inflation. This
strategy allows them to benefit from the high yield of the notes while protecting
potential decreases in yield.

Advantages And Disadvantages

Let’s compare the pros and cons of interest rate collars.

#1 – Pros
• The biggest advantage of any options collar is protection from risk. Hedging by
taking opposite stands establishes an interest rate ceiling and floor beyond which
the investor will not incur any losses. 

• It provides some control to investors as they can decide the upper and lower limits
of the interest rate that will affect the risk they are exposed to.

• Since the put option can be purchased using the premium from the call option,
the investor will incur low costs, if not zero costs.

• While bondholders are exposed to interest rate risk, they can receive minimum
guaranteed returns from the options collar.

#2 – Cons
• The most serious downside to the collar strategy is the limited returns from the
derivative contract. This is because of the cap and floor limits established by the
investor. For instance, suppose the interest rate increased more than the investor
predicted; they could not enjoy the full benefits.

• Also, if the investor’s original prediction is accurate, there would be no point in the
opposite stand the investor takes. It would be an unnecessary expenditure.

• While the collar is a zero-cost strategy, the investors still have to incur brokerage

3 of 8 18/6/2023, 2:49 pm
Firefox https://www.wallstreetmojo.com/interest-rate-collar/

fees and commissions while buying the put and selling the call options.

Interest Rate Collar vs Swap vs Cap
Let us understand the differences between interest rate collar, swap and cap:

• An interest rate swap can be defined as a forward contract where payments

based on interest rates are exchanged between two parties to the contract for a
fixed period. 

• As the term suggests, parties swap or exchange their interest rates. Fixed and
floating rates are mostly exchanged based on the conditions in the parties’
respective markets.

• As mentioned, an interest rate cap is an upper limit on how high the interest rates
of a particular instrument can rise. The investor establishes the ceiling and
protects themselves from losses beyond that limit.

• Interest rate swaps, caps, and collars are all risk management strategies that
investors use to minimize losses. 

• A collar is made up of a cap and a floor. While the cap sets the upper limit, the
floor sets the lower limit, and the investor only worries about interest rate
fluctuations in this range. Thus, a collar offers more protective coverage than a
cap.

• Swaps concern specific interest rates at which they are exchanged, but collars
specify a range.

Frequently Asked Questions (FAQs)

1. What is a reverse interest rate collar?
A reverse interest rate collar is a hedging strategy that provides protection against
declining interest rates. It involves buying an interest rate floor to guard against lower
rates while selling an interest rate cap to generate income. By combining these
positions, investors can mitigate the risk of decreasing interest rates while potentially
benefiting from limited upside potential.

2. What are the potential risks associated with interest rate collars?
There are several risks to consider when using interest rate collars. One risk is the
potential opportunity cost if interest rates exceed the collar’s predetermined range.
Additionally, the premium paid for purchasing the collar can incur upfront costs. 

3. How do interest rate collars impact cash flow and financial performance?
Interest rate collars can positively and negatively impact cash flow and financial
performance. On the positive side, collars provide a level of certainty and protection
against interest rate fluctuations, which can help stabilize cash flow. However, the
premiums paid for collars can reduce immediate cash availability. Financial
performance can be influenced by the extent to which the collar successfully mitigates
interest rate risk and the overall market conditions.

Recommended Articles

4 of 8 18/6/2023, 2:49 pm
Firefox https://www.wallstreetmojo.com/interest-rate-collar/

This has been a guide to what is Interest Rate Collar. We explain its examples, compare

it with swap and cap, and advantages, and disadvantages. You can learn more about it
from the following articles –

• Floating Rate Note

• Interest Rate Derivatives

• Synthetic Position

INVESTMENT BANKING RESOURCES

Learn the foundation of Investment banking, financial modeling,

valuations and more.

5 of 8 18/6/2023, 2:49 pm
Firefox https://www.wallstreetmojo.com/interest-rate-collar/

Join Wallstreetmojo Youtube

68.5K subscribers

FREE EXCEL RESOURCES

Learn MS Excel right from scratch. Master excel formulas, graphs,

shortcuts with 3+hrs of Video.

Join Wallstreetmojo Instagram

FREE FINANCE MODELING COURSE

Learn Financial Modeling in Excel with this Step by Step Guide

(Colgate Case Study)

6 of 8 18/6/2023, 2:49 pm
Firefox https://www.wallstreetmojo.com/interest-rate-collar/

Join Wallstreetmojo Linkedin

FINANCE DICTIONARY

Learn & Master Finance & Accounting with 5400+ Step by Step
Guides & Resources

Featured Guides
What is Call Option? 
What is Options Trading? 
What are Futures? 
Credit Default Swap 
What is Open Interest? 

7 of 8 18/6/2023, 2:49 pm
Firefox https://www.wallstreetmojo.com/interest-rate-collar/

Company Resources
About Blog
Reviews Investment Banking Resources
Contact Financial Modeling Guides
Privacy Policy Excel Resources
Terms of Service Accounting Resources
Cookie Policy Financial Statement Analysis
Advertise with us

Follow Us
 YouTube
 Facebook
 LinkedIn
 Twitter
 Instagram

Copyright © 2023 . CFA Institute Does Not Endorse, Promote, Or Warrant The Accuracy Or Quality Of WallStreetMojo. CFA® And Chartered Financial
Analyst® Are Registered Trademarks Owned By CFA Institute.

8 of 8 18/6/2023, 2:49 pm