An option-based strategy which is established by purchasing a European-style option (the cap) and selling of another (the floor), both on the same currencies and with the same expiration date. The two options provide together an exchange range in which exchange rates will be allowed to fluctuate in terms of the notional amount. In that sense, foreign exchange collars are used to minimize the cost of hedging and for managing foreign exchange risk. The exchange range is bounded by the upper and lower bands of the collar, which are created by the strike prices of the two options. The cap’s or call’s strike represents the upper band, while the floor’s or put’s strike makes up the lower band.
If exchange rates break out of the collar, either the call or the put will be exercised. Otherwise, neither will be exercised. This helps confine a given exchange rate to the upper and lower strike prices for the contract’s notional amount.
It is also known as a cylinder option, range forward, tunnel option, or zero-cost option.
Comments