An interest rate collar is a type of strategy used in investing to hedge the exposure an investor experiences in relation to fluctuations in interest rates. This is typically managed by using derivatives to hedge that exposure, effectively containing or collaring that the investor’s vulnerability to shifts in those interest rates. While an interest rate collar does have the effect of limiting the interest rate the investor will pay, it also leaves the investor open to the chance for additional profits if the interest rate should drop.
One type of investment opportunity that may be enhanced with the aid of an interest rate collar is bond issues. This is because the price of a bond decreases when interest rates increase. By using the collar to cap the decrease by setting a limit on the increase in interest rates, the investor is able to minimize the potential for sustaining a loss. At the same time, the collar is also used to create what is known as an interest rate floor. This is basically the rate of interest at which the investor will sell. The designation of both an interest rate ceiling and floor serves to allow the investor to project the anticipated return in both the worst case and best case scenarios. To a degree, this helps to reduce the level of interest rate risk associated with the investment.
For example, an interest rate collar on a bond issue may establish an interest rate maximum or ceiling of twelve percent, while identifying a floor of ten percent. Should the prevailing interest rate rise above that ceiling, the investor receives a payment from whoever purchased that ceiling, effectively offsetting the losses incurred due to the reduced value of the bond. At the same time, should the interest rate fall below the floor level, the investor must make a payment to whoever purchased that floor. That action offsets the profits the investor would otherwise earn from the increased value of the bond.
Often, the attention is focused on the ability of the interest rate collar to help investors avoid loss. The fact that the strategy also has the potential to limit the return is usually a secondary concern. This is fine, as long as the investor considers the maximum amount of return associated with a given collar to be equitable, even if the interest rate rises above the interest rate ceiling or falls below the interest rate floor.
