What is an Interest Rate Collar?
An Interest Rate Collar is a contractual agreement between two counterparties, the Borrower and the Bank.
It is a combination structure involving the effective purchase of an Interest Rate Cap and the simultaneous sale of an Interest Rate Floor. Typically, the premium of the cap is designed to exactly match that of the floor, with the result that they cancel each other out and produce a Zero Cost Collar.
For a Borrower who enters into a Zero Cost Collar, a known maximum interest rate payable (Cap strike rate) will be established at the cost of agreeing to pay a known minimum rate (Floor strike rate). Between those two levels, the cost of finance will remain on a floating rate basis over the agreed period of time.
How does it work?
On each three monthly reset date, the Cap and Floor strike rates will be compared with the contracted floating rate. If the relevant floating rate is equal to or below the Cap strike rate, while simultaneously being equal to or above the Floor Strike rate, no payment will be made.
If the relevant floating rate is above the Cap strike, the Bank will pay the Borrower the difference for the three month period.
If the relevant floating rate is below the Floor strike, the Borrower will pay the Bank the difference for the three month period.
- It provides the Borrower with a pre-agreed maximum rate of interest
- It provides the Borrower with the flexibility to benefit from low floating rates down to the minimum floor level
- Unlike a Cap, a Collar can be structured such that there is no upfront premium cost
- There may be additional costs arising on early termination due to the Borrower having to buy back the Floor. The Borrower will, however, be entitled to receive any residual value attributable to the Cap
- If the floating rate fails to rise above the Cap strike rate and / or remains below the Floor strike rate during the tenor of the Collar, the Borrower may feel that no value was received
Interest Rate Collar example: