Zero-cost collar

By buying the 4% strike cap and selling the 2.59% floor, the company would have a zero-cost collar, an interest rate collar structured so that there is no net premium paid. 

The payoff profile from this zero-cost collar is shown in Exhibit 17.28, which contrasts the company s borrowing cost when nnhedged with the collared rate. 

EXHIBIT 17.28 Effective Borrowing Cost for Zero-Cost Collar... 

Many option packages—like the zero-cost collar just describe—involve customers buying interest rate options to hedge an adverse market exposure, and then selling other options to offset or eliminate the cost. 

As an alternative to the zero-cost collar, some borrowers prefer a participating cap. This involves the company ... 

The net premium for this structure would therefore be zero, just like that of the zero-cost collar. This is a participating cap, and the payoff profile is illustrated in Exhibit 17.29. 

If EURIBOR sets above the strike rate of 3.5%, the cap purchased by the company limits the effective borrowing cost to 4.5%, 1% above the cap strike, while the floor for that period expires out-of-the-money. The company s maximum borrowing rate is therefore capped, in the same way as with a zero-cost collar. 

Like caps, floors are series of individual contracts. These are called floorlets, and they function essentially as put options on interest rates. Lenders may buy floors to limit their income losses should interest rates fall. A long call cap position combined with a short floor position is a collar, so called because it bounds the interest rate payable on the upside at the cap level and on the downside at the floor level. Zero-cost collars, in which the cap and floor premiums are identical, are very popular with corporations seeking to mantle their interest rate risk. 

As the chart shows, the company s unhedged cost is simply 1% over EURIBOR, reflecting the company s 1% credit margin. With the collar in place, the company s borrowing costs are unaffected when EURIBOR resets in-between the strike rates of 2.59% and 4%. This is because the collar has a zero cost, and neither the cap nor the floor are exercised when EURIBOR stays within this range. If, however, EURIBOR exceeds 4%, the cap compensates the company for the excess interest paid, capping the effective cost at 5%. Similarly, if EURIBOR fixes below 2.59%, the company s borrowing costs are floored at 3.59%. 

Maximum losses are floored at around 700,000, similar to those with the ATM options, but the up-front premium cost is almost zero, comparing very favourably with the cost of the ATM options in excess of 600,000. If the investor is wrong, and bond prices continue to rise, the investor can still enjoy the benefit of a rise in bond prices of more than 1.50% before the calls sold cap the investor s profits at around 800,000. For many investors in this position, the price collar is an excellent strategy. 

---