CFM13350 - Understanding corporate finance: derivative contracts: interest rate collars
The problem with interest rate caps is that, as with any option, the holder must pay an premium up-front. This may be substantial particularly if the company wants to hedge an interest rate exposure extending over a number of years.
One way to reduce the premium payable would be for the company to reduce the level of 'insurance cover' it buys. Thus, in the CFM13340 example, Sherflatt Ltd might buy an interest rate cap with a strike price of 6.5% rather than 6.0% - this would be cheaper but would, of course, mean that the company might have to pay more for its loan.
An alternative would be to 'cap' the borrowing rate at 6.0%, but to give up some of the company's potential to profit should interest rates fall. The option product allowing it to do this is called an interest rate collar.
A collar consists of a cap and a floor, transacted simultaneously. The bank sells the company an interest rate cap. At each fixing date, if the interest rate is above the cap, the bank will reimburse the company. But at the same time, the company sells the bank an interest rate floor. If, at a particular fixing date, the relevant interest rate is below the floor, the company reimburses the bank. The diagram illustrates how this works if, say, the cap is set at 6% and the floor at 3.75%.
The premium which the company would pay on the cap element is netted off against the premium it would receive on the floor element, so that the company will pay a much lower premium for an interest rate collar than it would for a cap. It might even pay no premium at all.