Question

. Draw a figure that reflects a firm with an interest rate collar with a floor of 2% (with a premium of 25 basis points) and a 5% ceiling or cap (with a premium of 50 basis points). Show where the strike price would be for the cap and floor on the X-axis. A. If the firm has a variable rate bank loan of $1M with a current market interest rate of 4% and expects interest rates to rise, should it buy a floor and sell a cap or vice versa to reduce its interest rate risk? Why? B. What is the benefit to the firm of setting up an interest rate collar rather than just having a floor or a cap by itself? C. If market rates rise to 6%, what happens? What happens if market rates fall to 2.5%?

Answer 1

In this graph,

Strike rate of written Floor = 2%

Floor premium = 25bsp = 0.25%

Strike rate of purchased Cap = 5%

Cap premium = 50bsp = 0.50%

A. If the firm expects the interest rates to rise, it should buy a Cap to set an upper limit on the interest payments of the variable rate loan.

Since the Cap option gives a right to the firm, the firm will have to pay a premium (known as the Cap Premium) to the bank for obtaining it.

B. The firm writes a Floor option alongside buying a Cap option because the premium received from writing the Floor offsets for the purchase of the Cap option. In the given example, while the firm has to shell out another 50 basis points for buying the Cap option (Strike rate of 5%), the firm receives 25 basis points for writing the Floor (strike rate of 2%) itself. Hence, the firm has to pay a net premium of 25 basis points for getting the Interest Rate Collar.

C. Whenever the interest rate is above 5% (say, 6%), the borrower (firm) will exercise the Cap and make interest payments basis the Cap Strike rate of 5%.

Whenever the interest rates are between the Floor strike rate and Cap strike rate, the firm will make the interest payments as per the market rates (in this case, 2.5%).