An interest rate collar that defines a maximum level and minimum level for the underlying base rate. In other words, it sets both the highest (cap) interest rate to be paid and the lowest (floor) interest rate that an investor may receive. If interest rates fall below the floor, the investor pays the collar’s seller (a bank, for example) the difference between the average base rate and the agreed floor rate. Notwithstanding, the investor can benefit when rates exceed the base rate cap, receiving the difference from the seller. For example, if a collar is set between 4% and 7%, then the cap would come into effect if the base rate exceeds 7% within its life, i.e., the collar’s holder receives interest. The floor would come into effect when rates drop below 4% during the period, in which case the holder would have to pay interest.
Derivatives
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