How do interest rate caps, floors, and collars work for hedging floating-rate debt?
I'm studying interest rate options for CFA Level II and keep getting confused between caps, floors, and collars. If a company has floating-rate debt, which one should they use? Can someone walk through a practical example with actual numbers showing payoffs at different rate scenarios?
Interest rate caps, floors, and collars are essential hedging tools for managing floating-rate exposure. Let's clarify each one with a concrete scenario.
Setup:
Granite Construction has a $100 million floating-rate loan at SOFR + 150bps, resetting quarterly. Current SOFR is 4.25%. The CFO wants to limit interest rate risk.
Interest Rate Cap:
A cap is a series of call options (caplets) on an interest rate. It pays off when the reference rate exceeds the cap rate.
- Granite buys a 3-year cap at 5.50% on SOFR
- Premium: 1.20% of notional ($1.2 million upfront)
- If SOFR rises to 6.00%, the caplet pays: (6.00% - 5.50%) x $100M x (90/360) = $125,000 per quarter
- Granite's effective rate is capped at 5.50% + 1.50% spread = 7.00%
Interest Rate Floor:
A floor is a series of put options (floorlets) on an interest rate. It pays off when the reference rate falls below the floor rate. Floors are typically bought by floating-rate lenders/investors who want to protect their income.
Interest Rate Collar:
A collar combines a long cap with a short floor (for a borrower). The premium received from selling the floor partially or fully offsets the cap premium.
- Granite buys the 5.50% cap (costs 1.20%)
- Granite sells a 3.50% floor (receives 0.80%)
- Net premium: 0.40% ($400,000)
- Effective SOFR range: 3.50% to 5.50%
Payoff Summary at Different SOFR Levels:
| SOFR | Cap Payoff | Floor Payoff | Net Position | Effective Rate (+ 150bps) |
|---|---|---|---|---|
| 3.00% | $0 | -$125,000 (pay out) | Floor limits downside benefit | 5.00% |
| 3.50% | $0 | $0 | No payoffs | 5.00% |
| 4.50% | $0 | $0 | No payoffs | 6.00% |
| 5.50% | $0 | $0 | At cap strike | 7.00% |
| 6.50% | +$250,000 | $0 | Cap limits upside cost | 7.00% |
Zero-Cost Collar:
If the floor premium exactly equals the cap premium, it's called a zero-cost collar. This is popular because there's no upfront cash outlay, but the borrower gives up the benefit of rates falling below the floor.
Exam tip: The CFA exam frequently asks which instrument a floating-rate borrower should use. Remember: borrowers buy caps (or collars) to protect against rising rates. Lenders buy floors to protect against falling rates. A collar gives up some downside benefit in exchange for a cheaper cap.
Practice more interest rate derivatives in our CFA Level II question bank on AcadiFi.
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