What Is a Fixed-Dollar Value Collar?
The fixed-dollar value collar refers to a strategy that a company acquired during a merger may apply. Through this method, the company can safeguard itself from fluctuations in the share price of the acquiring company.
A collar refers to an options trading strategy where the trader holds a long put position, a short call position, and is long shares of the underlying stock. The protective mechanism involves holding shares of a given stock, while also purchasing protective puts and selling call options against the holding. Both the puts and calls are out-of-the-money (OTM) options, with the same expiration month and equal in the number of contracts purchased.
- A fixed-dollar value collar is an options strategy employed during a merger to hedge against fluctuations in the share price of the acquiring company.
- Using both put and call options, the strategy sets both a floor and ceiling on the stock component of the acquisition deal.
- Fixed-dollar value collars set the exchange level for the company being bought to exchange its shares for the shares of the acquiring company.
- Though a fixed-dollar value collar creates a floor, it also caps the upside potential an investor can receive.
- A fixed-dollar value collar provides less flexibility compared to a variable-dollar collar, while a fixed-share collar strives to protect the number of shares in a transaction.
How a Fixed-Dollar Value Collar Works
A fixed-dollar value collar is one of two types of collars useful during mergers and acquisitions (M&A) deals. It is meant to protect the target company's assets, delivering a consistent dollar value for each of the seller's shares even if the acquiring company's stock price should drop. The aim of the fixed-dollar value collar is to be a circuit breaker, which might forestall significant losses. By setting a floor and ceiling on the stock component of an acquisition deal, the company doing the purchasing will commit to delivering a fixed-dollar value of its stock for each share of the company that is to be acquired.
Fixed-dollar value collars set the exchange ratio for the merger or acquisition deal. The ratio determines the share exchange level for the company being bought to exchange its shares for the shares of the acquiring company. This exchange ratio will fluctuate within the collar, as the strategy provides a floor and cap—minimum and maximum levels for the exchange.
Advantages and Disadvantages of Fixed-Dollar Value Collars
Pros of Fixed-Dollar Value Collars
The primary benefit of fixed-dollar value collars is the price floor that offers downside protection. This protects the collar bearer from excessive losses in the event that the asset's value decreases. However, the collar options still allows the investor to take part in the possible future gains of the underlying asset.
Compared to other risk management techniques, fixed dollar value collars may be applied at a comparatively modest cost. In an investment context, collars entail buying put options to set the price floor and selling call options to pay for the put options which may be more reasonably priced compared to other risk mitigation strategies. Investors can also fine-tune their desired level of upside participation and downside protection by adjusting the collar's price range, making collars somewhat flexible.
Collars are primarily useful instruments for reducing risk, especially in tumultuous markets or uncertain periods. They give investors the ability to manage their exposure to market volatility; therefore, collars have the added benefit of allowing an individual to plan easier for the future as there is a smaller band of variability.
Cons of Fixed-Dollar Value Collars
The fact that set dollar value collars restrict the investor's potential for profits is one of their key disadvantages. The investor effectively caps their share in the asset's upside by setting a price ceiling through the sale of call options. The investor will not reap the full benefits of a big increase in the asset's value.
To implement a collar strategy, you must first construct downside protection by purchasing put options, then you must finance those puts by selling call options. This does incur upfront transaction fees that are incurred even if the upper or lower band are not triggered.
Despite the downside protection offered by fixed dollar value collars, there is still a chance of suffering losses or reaching breakeven points. Losses for the investor will still occur even if the price of the underlying asset drops below the strike price of the put option. Additionally, the investor may pay expenses without receiving any real benefits if the market circumstances prevent the collar approach from being profitable or breakeven, meaning their cash outflow may still outpace their inflow.
Offers downside protection by creating a floor
Mitigates risk by creating upper and lower bands
Allows an investor to have some flexibility on those bands
May have tax efficiency capabilities
Often limits the upside potential of the investor
Incurs upfront costs, even if neither band limit is hit
May still result in next losses after factoring in fees
May cause tax or planning complexity
Fixed-Dollar Value Collar vs. Fixed-Share Collar
In the context of M&A, fixed-dollar value and fixed-share collar techniques are used to manage risk and safeguard the value of portfolios participating in these transactions.
Their goals and points, however, are where the two strategies diverge most. A fixed-dollar value technique works to keep the M&A transaction's dollar worth constant and within predetermined bounds. A fixed-share collar approach, on the other hand, concentrates on preserving the value of a set number of shares during the M&A process.
Additionally, each plan employs a different methodology. While a fixed-share collar strategy uses options contracts to define price ranges and safeguard shares from market volatility, a fixed-dollar value method includes altering the exchange ratio or purchase price to maintain the targeted dollar value. Investors must be
Despite these variations, both approaches still have much in common. Both of them are used for risk management in order to safeguard values from market changes. Each is meant to strengthen the overall risk management framework in M&A activities by providing protection against unfavorable market conditions and potential losses.
Companies often outline the details of collar strategies in transaction proposals to shareholders. For example, Rockwell Collins and United Technologies outlined the strategy in a letter to their shareholders filed with the SEC.
Fixed vs. Floating Exchange Rate
Investment solutions used to control risk and safeguard portfolio value cab include both fixed-dollar value collars and floating-dollar value collars. Both have the same goal of risk management and portfolio value preservation, as they both seek to lessen the portfolio's exposure to market swings and offer some amount of protection from possible losses.
The collar's design and adjustment are the main differences. A floating-dollar value collar modifies the collar in response to variations in the portfolio's value over time. The collar is widened to accommodate the larger value as the portfolio's value rises, providing for possible gains. On the other hand, if the value of the portfolio falls, the collar is shrunk to offer more protection against future losses. This is in contrast with a fixed-value collar that is not dynamic.
In some circumstances, where flexibility and market conditions adaptability are seen favorable, a floating-value collar may be preferred to a fixed-value collar. This is most often the case in high volatile periods or times where market uncertainty is high. This strategy may also be better for investments with longer-time horizons that may need to be changed or altered more frequently.
Example of Fixed-Dollar Value Collar
Imagine Company A wants to buy Company B. Company A wishes to preserve the transaction's value and guarantee that it stays within a predetermined dollar value range while also taking advantage of future market gains. They choose to use a fixed-dollar value collar technique. There would be a few steps to this strategy:
Step 1: Establish Collar Range. Let's say Company A decides on a fixed-dollar value range of between $50 million and $60 million for the M&A deal. This range depicts the targeted limits where they want to keep the transaction's value constant.
Step 2: Purchase Put Options. Company A purchases put options with a $50 million strike price in order to create a floor and safeguard against any downside risks. If the value of the transaction falls below this predetermined threshold, these put options give the buyer the opportunity to sell shares of the acquiring business at that price. This lessens the possibility of a big drop in the acquisition's value.
Step 3: Sell Call Options. Company A sells call options with a $60 million strike price in order to set a ceiling on future profits and generate money. If the transaction's value exceeds the stipulated cap, these call options force the purchasing corporation to sell its shares at that price. Company A makes premiums from the sale of these call options, adding to its income and helping to cover any potential transaction expenses.
Step 4: Monitor/Rebalance. Company A continuously analyzes the value of the transaction throughout the M&A process to make sure it stays within the fixed-dollar value range. The collar may need to be adjusted if the value is getting close to the upper or lower boundary. If possible, they might think about selling more shares if the transaction's value rises and goes above the upper limit in order to keep it within the intended range. On the other hand, if the value drops and gets close to the lower threshold, they might buy more shares to make the deal profitable again.
What Is the Purpose of Using a Fixed-Dollar Value Collar?
The purpose of using a fixed-dollar value collar is to manage risk and protect against potential losses or gains in a stock's price. The collar establishes an upper bound and lower bound in which the value of securities are confined to.
How Is the Collar's Price Range Determined?
A collar's price range is typically determined based on an investor's desired level of protection. It is often set by selecting a lower and upper price point within which the stock's price can fluctuate. The broader the range, the more the investor is willing the price to fluctuate.
What Are the Risks Associated With Fixed-Dollar Value Collars?
The risks associated with fixed-dollar value collars include potential opportunity costs if the stock's price exceeds the upper limit, transaction costs, and the risk of the stock's price falling below the lower limit. Note that in exchange for sacrificing upper limit profits, the investor is protected by potential downside risk.
How Do Fixed-Dollar Value Collars Differ From Other Hedging Strategies?
Fixed-dollar value collars differ from other hedging strategies in their specific structure and the way they limit both downside and upside potential. They combine elements of options trading and stock ownership to create a risk management tool. Other hedging strategies such as protective puts or covered calls may provide different risk management characteristics or focus primarily on one aspect of risk mitigation.
The Bottom Line
Fixed-dollar value collars are financial instruments designed to manage risk by limiting potential losses or gains in a stock's price. They combine stock ownership with selling call options and buying put options to create a range within which the stock's price can fluctuate. Fixed-dollar value collars offer a balanced risk-reward profile and provide protection against downside losses while capping potential upside gains.