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Hedging Interest Rate Risk Using Caps, Floors and Collars

Hedging Interest Rate Risk Using Caps, Floors and Collars

Interest rate cap: 

A cap involves using interest rate options to set a maximum interest rate for borrowers. If the actual interest rate is lower, the option is allowed to lapse.

Interest rate floors:

A floor involves using interest rate options to set a minimum interest rate for investors. If the actual interest rate is higher the investor will let the option lapse.

Interest rate collar:

A collar involves using interest rate options to confine the interest paid or earned within a pre-determined range. A borrower would buy a cap and sell a floor, thereby offsetting the cost of buying a cap against the premium received by selling a floor. A depositor would buy a floor and sell a cap.

Source: Ken Garrett , ACCA

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