I see a lot of questions asking to construct interest rate collars. In what cases will we buy the floor and sell the cap and in what cases will be sell the floor and buy the cap? can someone please explain??? Thanks!
if you have floating rate debt/liability - you want to hedge against rising rate- So Buy CAP if you have floating rate asset - you want to hedge against falling rate- So Buy FLOOR You can also buy cap and sell floor in the first scenario to keep your liability cost between floor and cap rate
I understand that part, however the part I don’t understand is when you buy and sell one of each SIMULTANEOUSLY. I don’t know which to purchase and sell at once. A lot of the questions I have encountered in the past used the sales proceeds to offset the purcahse of either a call or floor. I’m just trying to find out what to buy and sell SIMULTANEOUSLY. Further clarification is appreciated. Thanks!
Basically what chowder said is right. It depends on what you think rates will do in the future. Rates rise - buy cap, sell floor Rates down - buy floor, sell cap
you want to buy the derivative that will offset your exposure to the underlying. selling the other side results in the interest rate collar being cost-free (proceeds from sale offset the price of the purchase). so, using the above posts, say you have a loan outstanding on which you pay a floating rate. obviouslly you’re worried about rates going up, so you want to gain exposure to something that increases as rates increase (to offset any payments you’d have to make), which is exactly what an interest rate cap is (or a long FRA). you sell a floor and use the proceeds to buy a cap. if rates go down, the interest savings you have are offset by the payoff you have to make on the floor that you sold. so your true interest rate exposure is in between the floor and the cap rates.
Whichever one you buy, you should sell the opposite: Protect against interest rates going up - long cap, short floor A zero cost collar would be one where the proceeds from the short sale exactly offset the cost of the cap. Protect against interest rates going down - long floor, short cap Again, shorting the cap provides income towards the cost of the long floor. All you need to know for the test is how to calculate the payoff on a caplet or floorlet, which is pretty simple. Also it would be good to remember that a long cap can by equivalent to being long a put option on a fixed-income security (when rates go up, your derivative is in-the-money)
alright thanks!