How to Protect Investment Yields With Interest Rate Collars
Banks, financial institutions and other businesses with variable rate investments will often seek to reduce interest rate risk and protect the yield on these investments through use of an interest rate collar. Using an interest rate collar locks in a guaranteed range of investment return and protects the investment holder if the variable rate falls below the selected floor. The downside of such a collar is that it prevents the investment holder from benefiting should the variable rate exceed the selected rate cap.
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Instructions
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Determine the tolerable investment risk. Since the risk with a variable rate asset is that the variable interest rate will fall, this is typically expressed as the minimum interest rate the holder will accept on the asset. This will be the interest rate floor.
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Decide the acceptable level of the interest rate cap. The interest rate cap limits the investor's profits on the asset. Many investors will set the level of the interest rate cap to be equivalent to the cost of purchasing at the interest rate floor, in effect constructing what is known as a zero-cost collar.
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Sell an interest rate cap, indexed to the variable rate on your investment, with a duration equivalent to the life or planned maturity of your investment.
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Purchase an interest rate floor, indexed to the variable rate on your investment, with a duration equivalent to the life or planned maturity of your investment. Most investors will use the proceeds of the interest rate cap to purchase the interest rate floor.
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Tips & Warnings
An interest rate collar for entities seeking to protect investment yields is often called a reverse collar and is substantially different from the more common type of interest rate collar, which is used by entities seeking to limit interest rate risk on variable rate debt obligations.
These transactions are not for typical investors. Interest rate caps and interest rate floors for given values are not exchange traded securities, known as over-the-counter investments. Acquiring or selling these instruments requires entering into a contract with a third party. There are many brokers that will facilitate these transactions, although they are typically only interested in large volume transactions.
