Opting For An Interest Rate Collar

If you are a borrower who wants to ensure your interest rates are protected, there are several different tools that you can opt for. An interest rate cap, for example, is one of them. It protects borrowers from soaring market rates. On the other hand, if you are the other party who want to protect your interest rates as well by presenting the minimum rate that your borrowers must pay regardless of the lower fall for the market, you should opt for interest rate floor. And when these two are in place, an interest rate collar is best recommended.

An interest rate collar is the simultaneous purchase by the borrower of a cap and sale of a floor. This simultaneous purchase of the cap and the floor is effective for the same duration specified in the contract. In the business side, this is usually done to lower the cost of the premium rate that the borrower must pay while at the same time insure that it won’t get affected by the drastic movement in short term interest rates.

While borrowers enjoy the significant fall in market rates, they also tend to protect themselves against the rising interest rates by buying themselves a cap. To learn more about the interest rate collar, you should first know the following:

- It carries a prepayment risk
- It requires credit approval
- It is secured by the note of the underlying financing
- It entails borrowers to be prepared to shoulder the unwind cost upon an early termination should rates fall.
- It allows borrowers to realize a gain should rates rise
- It follows standardized documentation

borrower has what is called a Zero Cost Collar in the event wherein the premium of the floor is the same as the cost of the cap. It is equivalent to an interest rate swap wherein the simultaneous purchase of a cap and sale of a floor a floating rate loan is converted to a fixed rate one.

While this is not usually done because there aren’t many strikes that are well-supported, this happens from time to time. Most people prefer to use the collar strategy over the corridor simply because they worry over possible rate hikes.  Most of these floor participants are also inclined to sell a floor to reduce their costs than to offer another cap with a raised strike. And so, opting for an interest rate collar seems to be the best choice for most borrowers.