Greetings
Interest Cap,Floor and collars went over my head , i just don’t understand what they actually are.
As i remember from readings( i think its bond or equity) a floor will enable option write to pay at least that interest rate if interst rate goes down and cap will protect the option write to to pay only the interest rate if intrest rate goes really high.
But now, here is the dilema for me: CFAI text mentions that “combination of interst rate call is a cap”, and “combination from interest rate put is interest rate floor”
I just couldn’t able to imagine how a combination of interest rate call would be an interest rate cap.
Also what is this collar? A combination of interest rate caps and floors? what exactly does it mean?
I woul really appreciate, if anyone can explain this concept to me.
Thank you.
I just finished reading that section for the first time earlier this week, so please anyone correct me if I state anything incorrectly. My understanding is that the cap is a series of interest rate call options with expirations that coincide with your interest payments. Since the calls will have a positive return when rates rise, this increase will offset your increase in costs associated with your interest payments - thus “capping” your interest payments in a way. The same but opposite holds true with floor/puts. For the collar, you go long either floor or cap and then short the other. The short provides cash inflow to offset the long. For example, long the cap to offset a rise in interest rates and short the floor to pay for it. The result protects from a rise in interest rates, but you now have sacrificed your benefit if rates fall. Hope this helps.
If you have taken a loan on floating rate; it implies that the rate will reset after some specified time. In order to hedge your risk against unexpected rise in the interest rates you purchase interest rate calls. Through interest rate calls you hedge your risk and obviously they should have expiration equal to the reset dates. In this way for the life of the loan you purchase series of interest rate calls or caplets to effectively make a cap. In the same way you can sell the put options to make a floor. Selling multiple put options or floorlets with expiration matching the reset dates effectively make a floor. If you are long on calls it means that if interest rate > strike rate of the call you’ll receive the difference from the option writer. The payoff is calculated by multiplying the Notional amount (which is usually equal to the loan amount) with the difference of prevailing interest rate and strike rate. You pay till the strike rate from your pocket and receive the additional difference from the call option writer and make the total payment equal to the floating rate to the loan lender. In this way the maximum you pay is the cap. If interest rates fall below the floating rate (strike rate of put options) then you pay the prevailing floating rate to the loan lender and the difference of the strike rate and floating rate multiplied by Notional amount to the put option buyer, to whom you’ve written the put. In this way the minimum you pay is the floor. In this way the interest rate collar is created for borrower by going long on interest rate calls and short on interest rate puts.