What is an Interest Rate Collar? Definition, Components and Examples
Interest Rate Collar Definition
An interest rate collar is a risk management strategy designed to protect against interest rate fluctuations.
It involves the simultaneous purchase of an interest rate cap and the sale of an interest rate floor.
This combination creates an upper and lower limit, where the interest rates can fluctuate without causing any considerable financial impact.
Components of an Interest Rate Collar
Borrower
In the context of an interest rate collar, the borrower the entity looking for financial protection against interest rate fluctuations.
In a typical interest rate collar, the borrower would buy the cap and sell the floor.
Counterparty
The counterparty is the entity that provides financial protection against interest rate fluctuations for the borrower.
The counterparty is usually a financial institution, such as a bank or an investment bank.
In a typical interest rate collar, the counterparty would sell the cap and buy the floor.
Interest Rate Cap
The interest rate cap is the upper limit or maximum interest rate, and provides protection against interest rates rising above a certain level.
It represents the maximum rate the borrower will pay on the variable-rate debt.
If interest rates rise above the cap rate, the counterparty pays the borrower the difference between the actual rate and the cap rate.
For example. if a company has a cap rate of 6% on an interest rate collar and the market interest rate rises to 7%, the counterparty pays the borrower the 1% difference.
Interest Rate Floor
Conversely, the floor rate is the lower limit or the minimum interest rate, and provides protection against interest rates falling below a certain level.
It represents the minimum rate the borrower will pay on the variable-rate debt.
If interest rates fall below the floor rate, the borrower pays the counterparty the difference between the actual rate and the floor rate.
For example, if a company has a floor rate of 4% on an interest rate collar and the market interest rate falls to 3%, the borrower pays the counterparty the 1% difference.
Notional Principal
The notional principal represents the amount upon which the interest rate payments are calculated.
In the context of an interest rate collar, the notional principal is the loan amount that the collar is associated with.
For example, if the notional principal is £500,000 and the cap rate is 6%, and the floor rate is 4%, the borrower would make payments to the cap seller if the interest rate exceeds 6%, and the counterparty would make payments to the floor seller if the interest rate falls below 4%, all based on the £500,000 notional principal.
It is important to note that the notional principal is not actually exchanged between the borrower and the counterparty.
It is just used as the basis for calculating the payments associated with the interest rate movements.
Term
The term of the cap is the period of time that the cap is protecting the borrower.
Typically, the longer the term, the more expensive the cap is to purchase.
Interest Rate Collar Example
Now that we understand the definition and components of an interest rate collar, let’s look at a real-world example.
Imagine a company takes out a variable rate loan and is concerned about rising interest rates.
To protect against this risk, the company (borrower) decides to purchase an interest rate collar (from a counterparty).
The company sets the cap at 6%, which protects them from paying interest rates above this level.
Simultaneously, they set the floor at 4%, which ensures the company won’t benefit from interest rates falling below this threshold but keeps the cost of the collar down.
If interest rates fluctuate between 4% and 6%, the company will just continue to pay the variable rate on the loan without any additional costs or benefits from the collar.
However, if rates exceed 6%, the cap seller compensates the company for the excess costs.
On the other hand, if rates fall below 4%, the company compensates the floor buyer.
Advantages of Interest Rate Collars
There are a number of advantages to using interest rate collars:
Predictable Costs
The primary purpose of interest rate collars is to manage interest rate risk, which in turn provides a level of certainty to the business when it comes to interest costs.
By knowing the range of interest rate costs they are liable for, businesses can have more predictable cash flows, which is particularly important for budgeting and financial planning.
For example, a business could have an interest rate collar where they know that their yearly interest cost will be in the range of £36,713 in the higher end, and £21,425 in the lower end, which helps them to plan cashflow for the year.
Risk Mitigation
Interest rate collars are designed to mitigate the impact of interest rate volatility.
By setting upper and lower limits, businesses can protect themselves from unexpected changes in interest rates.
Customisation
Collars can be tailored to meet the specific needs and risk tolerances of a business.
This customisation mainly involves deciding on the cap rate and floor rate, to set the upper and lower limit of the interest costs they have to pay.
For example, a company with a lower risk appetite may decide on an interest rate collar with a cap rate of 5% and a floor rate of 3%, whereas a company with a higher risk tolerance may choose a cap of 7% and a floor of 4%.
Low Cost
Businesses do not pay premiums for both the cap and the floor.
Instead, they pay a premium for the cap and receive a premium for the floor.
The net premium paid or received depends on the specific terms of the collar, but can be structured in a way where the premium received from selling the floor helps to offset the cost of purchasing the cap.
Disadvantages of Interest Rate Collars
While interest rate collars can benefit a business, it is also important to consider the disadvantages:
Limited Upside
While interest rate collars provide a protective range, they also limit the upside potential for businesses if interest rates fall below the floor.
In a situation where interest rates are declining, the business won’t benefit from lower rates.
For example, imagine a business has a collar with a cap at 6% and a floor at 4%.
If interest rates fall to 3%, the business still pays the floor rate of 4%, missing out on potential interest cost savings.
Complexity and Understanding
Interest rate collars can be complex, and require a good understanding of market conditions and financial instruments.
Businesses that lack expertise in these areas may find it difficult to fully understand how these instruments work.