Interest Rate Collar


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.

  1. Hedge

    Making an investment to reduce the risk of adverse price movements ...
  2. Collar Agreement

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

    An over-the-counter investment instrument that protects the floor ...
  4. Interest Rate Risk

    The risk that an investment's value will change due to a change ...
  5. Interest Rate Ceiling

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

    A type of positive-carry collar that secures a return through ...
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