Interest Rate Collar

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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.

INVESTOPEDIA EXPLAINS'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.

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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 >>
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    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 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 >>
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