Interest rate Collar net, benefit, interest, exercise, understand

Zesty

on page 454 Volume 5. It is stated at the bottom paragraph:

" A collar establishes a range, the cap exercise rate minus the floor exercise rate, within which there is interest rate risk. The borrower will benefit from falling rates and be hurt by rising rates within that range. Any increases above the cap exercise rate will have no net effect, and any decreases below the floor exercise rate will have no net effect."

I am not sure I understand what they are trying to say here. Even their examples seems to show the contrary to those statements. if rates are falling toward the floor exercise rate, that leads to the cap being out of the money but the floor being still in the money. This increases the effective interest rate. So how is the borrower benefiting from this?

Also if rates rise above the cap exercise rate, then the cap is in the money but the floor is out of the money. This should lower the effective interest rate, not have no effect.

Is anyone seeing it differently? I am thinking I am just not getting what they are trying to say here.

Help appreciated.

Windjam

I have borrowed money at a floating interest rate. If interest rates go high, I am at a loss and if intrest rates go low, I benefit. Correct?

To protect myself from any rising interest rates in future, I buy a cap. Meaning, if interest rates go higher than the cap rate, I still pay only the cap rate on my borrowings.

Now, buying a cap has cost me some money. I may want to recover all or part of that money by selling a floor. Selling a floor means, if interest rates go down below floor rates, I dont get any benefits, I still pay interest on my borrowings at the floor rate.

So, by getting into a Collar position, the highest rate I have to pay on my borrowings is the Cap Rate and the lowest rate I could pay on my loan is the floor rate. I have fixed my range, and hence my interest rate risk, irrespective of market interest rates going above or below that range.

So, the below statement from the text is correct.

"Any increases above the cap exercise rate will have no net effect, and any decreases below the floor exercise rate will have no net effect."

Darien

Thanks rus1bus...And welcome back...I think I got it now...I was being thrown off by the "no net effect statement" but they are right...if say rates fall below the strike of the floor say 3% vs 5% strike...you will pay interest on the 3% actual rate BUT you also pay the difference between 5 and 3 since you are short the floor, and it is in the money. So you end up paying 5% anyways. Same logic applies when rates go above the cap strike. By no net effect I thought they meant that you just pay the actual borrowing rate (LIBOR).

thanks very much buddy and good luck on your studying...we are almost there

dyga

Thanks buddy and good luck to you too. Good to be back on the forum.

I am still doing behavioural finance and lagging far behind this time. But I wont give up and continue to be motivated here at the forum