Interest Rate Collar: a Worked Example

A borrower on a floating rate pays a base rate that moves with the market, such as BKBM in New Zealand, BBSY in Australia or SONIA in the UK, plus a margin that does not. A cap protects it against the base rate rising, but the premium is paid on day one, and for a three- or five-year cap it can be a large cheque. A collar pays for the cap by selling the bank a floor. The premium the bank would pay for the floor is set against the premium for the cap; when the strikes are chosen so that the two match, the structure is sold as a zero-cost or nil-premium collar. The zero describes the upfront payment only. The bank's margin is built into where the strikes sit, and the obligation under the floor remains.

That obligation is why the lender cares. A bought cap, once paid for, leaves the borrower owing the bank nothing. A collar can leave it owing money at each settlement and on any early close, so the bank approves it against a derivative credit limit, as it would a swap, and its security documents usually secure it alongside the loan.

The collar is a separate contract from the loan, usually documented under an ISDA master agreement and settled each interest period against the same base-rate fixing the loan uses. The loan itself stays floating; the collar's payments move the borrower's net cost into the band. The moving parts are the two strikes, the term, the notional (which can step down as the loan amortises) and any premium. Raising the floor lets the cap come down for the same nil premium, and the band narrows. Close the band entirely, with cap and floor at one rate, and the collar behaves like a swap at that rate. Variants exist. The UK review of hedging sold to non-sophisticated, mostly small, business customers, which the main banks agreed with the regulator in 2012, treated simple and structured collars separately: under a structured collar the borrower's rate can rise when the base rate falls below the floor.

A marina operator, constructed for this page like every figure in it, has a US$12m floating-rate term loan at the base rate plus a 2.10% margin. Its bank offers a three-year collar on the full amount with a cap at 4.75% and a floor at 3.25%, at no upfront premium; a three-year cap alone at 4.75% would cost US$190,000 on day one. The strikes, the margin and the premium are the example's, not a market quote. A year's interest on US$12m:

The operator's interest now sits between US$642,000 and US$822,000 a year, whatever the market does. With the cap alone it would have had the same ceiling, paid US$190,000 up front, and kept every fall in rates. The collar saved the premium by selling the falls below 3.25%.

Eighteen months in, the operator sells the marina and repays the loan. The base rate is 2.50% and the market expects it to stay there. The cap is now worth almost nothing; the floor is worth to the bank about 0.75% a year on US$12m, or US$90,000 a year, for the year and a half left: roughly US$135,000 before discounting, and that is broadly what the operator pays to close the collar. A bought cap would have closed at whatever value it had left, paid to the operator.

The three hedges sit on one line. A cap buys protection and keeps the upside, at a price paid now. A swap buys certainty at no upfront price, and gives up every fall in rates. A collar sits between: some certainty, some upside, little or no premium, and a two-way obligation like the swap's. Which suits a business turns on whether it needs a fixed number for its budget or only a worst case its cash flow can carry.

The collar's floor is also distinct from an interest rate floor on the loan. A loan floor, often set at zero, protects the lender's return by stopping the loan's base rate falling below it. A collar's floor is an option the borrower has sold. A file can carry both, and their levels should be read together.

DEFINED IN ONE PARAGRAPH → · THE CAP, DEFINED → · A SWAP, FROM THE BORROWER'S SIDE →

It changes three things. The first is the debt service a lender can test. With a collar in place, the cap rate plus the margin is a known worst case, and the lender can model the business at that rate rather than guessing at a stressed one. Where the facility requires part of the debt to be hedged, the lender checks that the agreement counts a collar, and on what notional, towards the hedge ratio.

The second is the credit approval. The collar uses a derivative limit and is secured with the loan, so a refinance or a sale has to close it or move it, and a close-out amount owed under the floor joins the figure needed to repay the bank. The third is understanding. The lender wants the file to show that the borrower knew what it sold, that its board approved it, and that it sits inside its hedging policy: a floor that comes as a surprise when rates fall is the start of a dispute.

DERIVATIVE CREDIT LIMIT → · FIXED VS FLOATING RATE → · THE BASE RATE, DEFINED →