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.

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.

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. Investing

    Who determines interest rates?

    In countries using a centralized banking model, interest rates are determined by the central bank. In the first step of interest rate determination, the government's economic observers create ...
  2. Economics

    Forces Behind Interest Rates

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

    An Introduction To Swaps

    Learn how these derivatives work and how companies can benefit from them.
  4. 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.
  5. 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.
  6. Investing

    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 is the main driving force behind investors not wanting to invest in ...
  7. Investing

    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, there are methods and policies by which the government's actions ...
  8. 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.
  9. Bonds & Fixed Income

    How does face value differ from the price of a bond?

    Discover how bonds are traded as investment securities and understand the various terms used in bond trading, including par value, market price and yield.
  10. Bonds & Fixed Income

    Why is my bond worth less than face value?

    Find out how bonds can be issued or traded for less than their listed face values, and learn what causes bond prices to fluctuate in the secondary market.

You May Also Like

Hot Definitions
  1. Prospectus

    A formal legal document, which is required by and filed with the Securities and Exchange Commission, that provides details ...
  2. Treasury Bond - T-Bond

    A marketable, fixed-interest U.S. government debt security with a maturity of more than 10 years. Treasury bonds make interest ...
  3. Weight Of Ice, Snow Or Sleet Insurance

    Financial protection against damage caused to property by winter weather specifically, damage caused if a roof caves in because ...
  4. Weather Insurance

    A type of protection against a financial loss that may be incurred because of rain, snow, storms, wind, fog, undesirable ...
  5. Portfolio Turnover

    A measure of how frequently assets within a fund are bought and sold by the managers. Portfolio turnover is calculated by ...
  6. Commercial Paper

    An unsecured, short-term debt instrument issued by a corporation, typically for the financing of accounts receivable, inventories ...
Trading Center