Learning Outcomes
After reading this article, you will be able to explain the structure and application of caps, floors, and collars as options-based hedging tools for interest rate risk. You will distinguish these strategies from other risk management tools, identify their suitability in different scenarios, and analyse the cost-benefit considerations, including the trade-off between protection and flexibility. By the end, you should be able to assess, compare, and recommend effective hedging approaches using options strategies in practical cases.
ACCA Advanced Financial Management (AFM) Syllabus
For ACCA Advanced Financial Management (AFM), you are required to understand the use of option-based derivatives to manage interest rate risk. In particular, you should focus on:
- The operation and appraisal of options as hedging instruments, including caps, floors, and collars
- The cost and benefit assessment of option-based hedges versus other risk management tools
- Evaluation of hedging effectiveness for specific exposures, including scenarios requiring both risk protection and financial flexibility
- How to select and justify an appropriate hedging method for a given risk profile
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
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Which of the following best describes a collar strategy in hedging interest rate risk?
- Buying both a cap and a floor
- Buying a cap and selling a floor with different exercise prices
- Selling a cap and buying a floor
- Buying a call and a put option with the same strike
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What is the primary advantage of a collar compared to a straight cap, from the hedger’s standpoint?
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True or false? An interest rate floor is used by a borrower to set a maximum cost for future borrowings.
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A company plans to deposit funds for three months but is worried about interest rates falling. Briefly explain how a floor could help.
Introduction
Managing exposure to fluctuating interest rates is a central concern for financial managers. Options-based products, such as caps, floors, and collars, are well-established strategies to hedge these risks. Each approach offers different combinations of protection and cost. Understanding their mechanics, applications, and decision points is critical for achieving risk management objectives while balancing financial flexibility with expense.
This article explains each of these instruments, shows how to combine them, and outlines considerations for practical use.
Key Term: interest rate cap
An agreement giving the holder the right to benefit if a reference interest rate rises above a set strike level. The cap sets a maximum cost for a borrower by paying the difference if rates exceed the cap.Key Term: interest rate floor
An agreement giving the holder the right to benefit if a reference rate falls below a set strike level. A floor sets a minimum return for a lender or investor, compensating them if rates drop below the floor.Key Term: interest rate collar
A strategy combining purchase of a cap and sale of a floor (or vice versa) with different exercise prices. It limits exposure by setting both a maximum and minimum rate, reducing net upfront premium cost.
OPTIONS STRATEGIES FOR INTEREST RATE RISK
Caps: Protecting Against Rising Rates
Borrowers with floating rate debt face the risk of interest rates rising. Purchasing a cap restricts the maximum interest rate payable to a specified “cap rate.” If the reference rate exceeds this level, the cap pays the difference, offsetting the higher borrowing cost. In return for this protection, the borrower pays a premium to the provider.
Cap characteristics:
- Suitable for borrowers aiming to set a cost ceiling
- Premium required upfront (cost increases with longer duration, greater volatility, or a lower cap rate)
- Retains advantage of lower rates if market rates fall
Floors: Protecting Against Falling Rates
Lenders or investors with floating rate assets (or deposits) risk lower revenue if market rates drop. Purchasing a floor allows them to guarantee a minimum rate of return. If the reference rate falls below the floor, the floor compensates the holder for the shortfall.
Floor characteristics:
- Appropriate for depositors or investors seeking a return floor
- Premium payable for protection
- Allows participation in any rate increase
Collars: Setting a Range with Cost Offsetting
A collar involves combining a cap and a floor—a common arrangement is for a borrower to buy a cap (for protection against rising rates) and simultaneously sell a floor (forfeiting gains if rates fall below a certain level). The premium received for the floor reduces or even eliminates the cost of the cap.
Collar characteristics:
- Used by borrowers to limit upside risk at lower premium cost
- Sets both a maximum (cap strike) and minimum (floor strike) rate
- Effective premium is lowered, but flexibility in benefiting from all rate movements is reduced (rates below the floor no longer provide future saving)
Key Term: option premium
The upfront cost paid by the option buyer to obtain the right (but not the obligation) to exercise the option for the cap or floor.
Worked Example 1.1
A company expects to borrow $10 million for six months at a floating rate pegged to SOFR, currently 5.0%. To hedge, it considers two alternatives: (A) buying a cap at 5.5% for a premium of $30,000, or (B) implementing a collar by buying a 5.5% cap and selling a 4.5% floor, reducing the net premium to $10,000.
- If SOFR rises to 7.0%, what is the interest rate paid under each hedging method?
Answer:
For both strategies, the borrower pays market rate up to the cap, and is compensated for rate above the cap.
Cap: Pays 5.5%; receives compensation for 1.5% excess (7.0% - 5.5%).
Collar: Same payment, since SOFR is above cap, the floor is not relevant.
In both cases, effective borrowing rate after cap payout is 5.5%, but the collar costs less up front.
If SOFR falls to 4.0%:
Cap: Pays actual rate (4.0%), enjoying full benefit of low rates (minus premium).
Collar: The floor seller compensates counterparty for the 0.5% difference (4.5% - 4.0%), so borrower effectively pays 4.5%.
Effectiveness, Suitability, and Cost Factors
Option-based strategies provide targeted risk reduction, but do not eliminate all exposure or all opportunity. Choosing between a cap, floor, and collar depends on the company's objectives, market expectations, and budget for premium.
- Caps and floors offer maximum flexibility (but are costlier).
- Collars reduce (or sometimes remove) net upfront cost, but restrict the benefit of favourable rate movements beyond one side of the range.
Worked Example 1.2
A treasury team is considering hedging upcoming deposit returns. Deposit rates are currently 3.0%. They can buy a floor at 2.8% for $5,000 or implement a collar, buying a 2.8% floor and selling a 3.2% cap, incurring no net premium.
If rates fall to 2.5%, what is the effect?
Answer:
With the standalone floor, the depositor receives compensation to maintain a 2.8% minimum yield, minus the $5,000 premium.
With the collar, they also receive the top-up to 2.8%, but if rates rise above 3.2%, any additional benefit is lost—interest income is capped at 3.2%. Thus, protection is present, but upside is limited in exchange for the lower cost.
Revision Tip
For ACCA exams, always specify who benefits from each option instrument (borrower or depositor), and clarify whether the strategy allows unlimited participation in rate movements, or fixes a range.
Exam Warning
It is easy to confuse the direction of caps and floors. Remember: borrowers hedge with caps, depositors hedge with floors. The opposite does not provide the intended protection.
Summary
Options strategies enable firms to limit exposure to adverse rate movements, but the trade-off is between upfront cost and flexibility. Caps protect against rising rates; floors against falling rates. Collars create a band of rates, reducing cost, but impose limits on the benefits from market movements outside that range. Selecting the right strategy demands clear assessment of risk appetite, cost considerations, and corporate objectives.
Key Point Checklist
This article has covered the following key knowledge points:
- Explain the practical purpose of interest rate caps, floors, and collars
- Describe the structure and payoff of each tool
- Identify which strategy is suitable for borrowers or depositors
- Compare the flexibility, cost, and effectiveness of caps, floors, and collars
- Recognise common exam errors and precisely describe hedging outcomes
Key Terms and Concepts
- interest rate cap
- interest rate floor
- interest rate collar
- option premium