Derivatives - caps and floors designed, decrease, potential, interest, increase

ikoreaii

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An investor with a variable-rate loan who wants to protect herself from an increase in interest rates without sacrificing potential gains from an interest rate decrease should purchase:
A. a bond call option
B. an interest rate cap
C. an interest rate cap and sell an interst rate floor


Answer:
B. Interest rate caps are designed to protect floating-rate borrowers from higher interest rates by paying the borrowers when rates reach a certain level. The combination of a long cap and short floor is called a collar and offers downside protection at the cost of a sacrifice of upside. A bond call option wil gain if interest rates decrease, not if they increase.
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Buying the rate cap makes sense in protecting against rate rises and if the rates decrease then she will benefit from a lower rate. So the answer makes sense

However, this does not make sense to me: "…short floor is called a collar and offers downside protection at the cost of a sacrifice of upside." If she writes a floor then she is only helping to offset some of her costs for the long cap - if the rates go below the floor then she will need to pay. I fail to understand how this is a downside protection?

waldziuchna

> However, this does not make sense to me: "…short
> floor is called a collar and offers downside
> protection at the cost of a sacrifice of upside."
> If she writes a floor then she is only helping to
> offset some of her costs for the long cap - if the
> rates go below the floor then she will need to
> pay. I fail to understand how this is a downside
> protection?

downside in this case is the interest rates going UP and upside here is interest rates coming down on someone who is paying a variable rate loan. So a collar caps the upside ( when the rates going down) but offers downside protection(when the rates go up).

suyash1989

Thanks guys, great explanation.

If she sees a short term rise in the variable rate - is collar the best way to maximize the gains? If so, then let's say the rates:

Went up: the long cap would offer downside protection and writing a floor would offset a part of that cost.

Went down: benefit from a low rate albeit only up to the floor minus the floor premium (received earlier for writing the floor). Anything below this point will be her LOSS.

Does this sound right?