Interest Rate Collar

AAA

DEFINITION of 'Interest Rate Collar'

An investment strategy that uses derivatives to hedge an investor's exposure to interest rate fluctuations. The investor purchases an interest rate ceiling for a premium, which is offset by selling an interest rate floor. This strategy protects the investor by capping the maximum interest rate paid at the collar's ceiling, but sacrifices the profitability of interest rate drops.

BREAKING DOWN 'Interest Rate Collar'

An interest rate collar can be an effective way of hedging interest rate risk associated with holding bonds. Since a bond's price falls when interest rates go up, the interest rate cap can guarantee a maximum decline in the bond's value. While interest rate floor does limit the potential appreciation of a bond given a decrease in rates, it provides upfront cash to help pay for the cost of the ceiling.

Let's say an investor enters a collar by purchasing a ceiling with a rate of 10% and sells a floor at 8%. Whenever the interest rate is above 10%, the investor will receive a payment from whoever sold the ceiling. If the interest rate drops to 7%, which is under the floor, the investor must now make a payment to the party that bought the floor.

RELATED TERMS
  1. Collar Agreement

    An arrangement in a merger and acquisition deal that protects ...
  2. Interest Rate Floor

    An over-the-counter investment instrument that protects the floor ...
  3. Hedge

    Making an investment to reduce the risk of adverse price movements ...
  4. Interest Rate Ceiling

    The maximum interest rate that a financial institution can charge ...
  5. Zero Cost Collar

    A type of positive-carry collar that secures a return through ...
  6. Interest Rate Risk

    The risk that an investment's value will change due to a change ...
Related Articles
  1. Economics

    Forces Behind Interest Rates

    Get a deeper understanding of the importance of interest rates and what makes them change.
  2. Options & Futures

    An Introduction To Swaps

    Learn how these derivatives work and how companies can benefit from them.
  3. Active Trading

    How Companies Use Derivatives To Hedge Risk

    Derivatives can reduce the risks associated with changes in foreign exchange rates, interest rates and commodity prices.
  4. Investing Basics

    Interest Rates And Your Bond Investments

    By understanding the factors that influence interest rates, you can learn to anticipate their movement and profit from it.
  5. Bonds & Fixed Income

    Advanced Bond Concepts

    Learn the complex concepts and calculations for trading bonds including bond pricing, yield, term structure of interest rates and duration.
  6. Options & Futures

    Understanding How Dividends Affect Option Prices

    Learn how the distribution of dividends on stocks impacts the price of call and put options, and understand how the ex-dividend date affects options.
  7. Mutual Funds & ETFs

    Top 3 Switzerland ETFs

    Explore detailed analysis and information of the top three Swiss exchange-traded funds that offer exposure to the Swiss equities market.
  8. Investing News

    Fund Firm Jolts: Pimco's Isn't The First Or Worst

    When you business is built on prudence and trust, a lot can go wrong to cost you tons of clients and assets. Here are a few examples.
  9. Mutual Funds & ETFs

    ETF Analysis: iShares JPMorgan USD Emerg Markets Bond

    Learn about the iShares JPMorgan USD Emerging Markets Bond fund, which invests in bonds of sovereign and quasi-sovereign entities from emerging markets.
  10. Investing Basics

    What's a Treasury Note?

    A treasury note is a U.S. government debt security that offers a fixed interest rate and a maturity date that ranges between one and 10 years.
RELATED FAQS
  1. Who determines interest rates?

    In countries using a centralized banking model, interest rates are determined by the central bank. In the first step of ... Read Full Answer >>
  2. Why do low interest rates cause investors to shy away from the bond market?

    The lower rates that are found on bonds, especially government-backed bonds, are often not seen as enough by investors. This ... Read Full Answer >>
  3. How does the government influence the securities market?

    Governments generally say they don't like to take an active role in the securities market (except for regulating it); however, ... Read Full Answer >>
  4. What are the maximum Social Security disability benefits?

    The maximum Social Security disability benefit amount for a single eligible person in 2015 is $1,165 per month, but you can ... Read Full Answer >>
  5. What is the relationship between the current yield and risk?

    The general relationship between current yield and risk is that they increase in correlation to one another. A higher current ... Read Full Answer >>
  6. How do futures contracts roll over?

    Traders roll over futures contracts to switch from the front month contract that is close to expiration to another contract ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Financial Crisis

    A situation in which the value of financial institutions or assets drops rapidly. A financial crisis is often associated ...
  2. Election Period

    The period of time during which an investor who owns an extendable or retractable bond must indicate to the issuer whether ...
  3. Shanghai Stock Exchange

    The largest stock exchange in mainland China, the Shanghai Stock Exchange is a nonprofit organization run by the China Securities ...
  4. Dead Cat Bounce

    A temporary recovery from a prolonged decline or bear market, followed by the continuation of the downtrend. A dead cat bounce ...
  5. Bear Market

    A market condition in which the prices of securities are falling, and widespread pessimism causes the negative sentiment ...
  6. Alligator Spread

    An unprofitable spread that occurs as a result of large commissions charged on the transaction, regardless of favorable market ...
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!