================ An investor with a variable-rate loan who wants to protect herself from an increase in interest rates without sacrificing potential gains from an interest rate decrease should purchase: A. a bond call option B. an interest rate cap C. an interest rate cap and sell an interst rate floor Answer: B. Interest rate caps are designed to protect floating-rate borrowers from higher interest rates by paying the borrowers when rates reach a certain level. The combination of a long cap and short floor is called a collar and offers downside protection at the cost of a sacrifice of upside. A bond call option wil gain if interest rates decrease, not if they increase. ================ Buying the rate cap makes sense in protecting against rate rises and if the rates decrease then she will benefit from a lower rate. So the answer makes sense However, this does not make sense to me: “…short floor is called a collar and offers downside protection at the cost of a sacrifice of upside.” If she writes a floor then she is only helping to offset some of her costs for the long cap - if the rates go below the floor then she will need to pay. I fail to understand how this is a downside protection?
> However, this does not make sense to me: “…short > floor is called a collar and offers downside > protection at the cost of a sacrifice of upside.” > If she writes a floor then she is only helping to > offset some of her costs for the long cap - if the > rates go below the floor then she will need to > pay. I fail to understand how this is a downside > protection? downside in this case is the interest rates going UP and upside here is interest rates coming down on someone who is paying a variable rate loan. So a collar caps the upside ( when the rates going down) but offers downside protection(when the rates go up).
Trekker Wrote: ------------------------------------------------------- > ================ > An investor with a variable-rate loan who wants to > protect herself from an increase in interest rates > without sacrificing potential gains from an > interest rate decrease should purchase: > A. a bond call option > B. an interest rate cap > C. an interest rate cap and sell an interst rate > floor > > > Answer: > B. Interest rate caps are designed to protect > floating-rate borrowers from higher interest rates > by paying the borrowers when rates reach a certain > level. The combination of a long cap and short > floor is called a collar and offers downside > protection at the cost of a sacrifice of upside. A > bond call option wil gain if interest rates > decrease, not if they increase. > ================ > > Buying the rate cap makes sense in protecting > against rate rises and if the rates decrease then > she will benefit from a lower rate. So the answer > makes sense > > However, this does not make sense to me: “…short > floor is called a collar and offers downside > protection at the cost of a sacrifice of upside.” > If she writes a floor then she is only helping to > offset some of her costs for the long cap - if the > rates go below the floor then she will need to > pay. I fail to understand how this is a downside > protection? Remember she has a variable rate loan. If she sells a floor at 2%, if interest rates drop below 2% she will have to pay someone but her loan expense will go down as well. Maybe she can even match them up so that any interest rate less than 2% results in the same net payment for her.
Thanks guys, great explanation. If she sees a short term rise in the variable rate - is collar the best way to maximize the gains? If so, then let’s say the rates: Went up: the long cap would offer downside protection and writing a floor would offset a part of that cost. Went down: benefit from a low rate albeit only up to the floor minus the floor premium (received earlier for writing the floor). Anything below this point will be her LOSS. Does this sound right?