How do interest rate caps, floors, and collars work for hedging floating-rate debt?

Question

AcadiFi · Accepted Answer

Interest rate caps, floors, and collars are essential hedging tools for managing floating-rate exposure. Let's clarify each one with a concrete scenario.

**Setup:**
Granite Construction has a $100 million floating-rate loan at SOFR + 150bps, resetting quarterly. Current SOFR is 4.25%. The CFO wants to limit interest rate risk.

**Interest Rate Cap:**
A cap is a series of call options (caplets) on an interest rate. It pays off when the reference rate exceeds the cap rate.

- Granite buys a 3-year cap at 5.50% on SOFR
- Premium: 1.20% of notional ($1.2 million upfront)
- If SOFR rises to 6.00%, the caplet pays: (6.00% - 5.50%) x $100M x (90/360) = **$125,000** per quarter
- Granite's effective rate is capped at 5.50% + 1.50% spread = **7.00%**

**Interest Rate Floor:**
A floor is a series of put options (floorlets) on an interest rate. It pays off when the reference rate falls below the floor rate. Floors are typically bought by floating-rate lenders/investors who want to protect their income.

**Interest Rate Collar:**
A collar combines a long cap with a short floor (for a borrower). The premium received from selling the floor partially or fully offsets the cap premium.

- Granite buys the 5.50% cap (costs 1.20%)
- Granite sells a 3.50% floor (receives 0.80%)
- Net premium: 0.40% ($400,000)
- Effective SOFR range: 3.50% to 5.50%

```mermaid
flowchart LR
    subgraph "Rate Scenarios for Granite Construction"
        A["SOFR = 3.00%"] --> B["Floor triggered: Granite pays counterparty"]
        C["SOFR = 4.50%"] --> D["Neither triggered: Pay floating"]
        E["SOFR = 6.50%"] --> F["Cap triggered: Granite receives payment"]
    end
    B --> G["Effective SOFR locked at 3.50%"]
    D --> H["Effective SOFR = 4.50%"]
    F --> I["Effective SOFR capped at 5.50%"]
```

**Payoff Summary at Different SOFR Levels:**

| SOFR | Cap Payoff | Floor Payoff | Net Position | Effective Rate (+ 150bps) |
|---|---|---|---|---|
| 3.00% | $0 | -$125,000 (pay out) | Floor limits downside benefit | 5.00% |
| 3.50% | $0 | $0 | No payoffs | 5.00% |
| 4.50% | $0 | $0 | No payoffs | 6.00% |
| 5.50% | $0 | $0 | At cap strike | 7.00% |
| 6.50% | +$250,000 | $0 | Cap limits upside cost | 7.00% |

**Zero-Cost Collar:**
If the floor premium exactly equals the cap premium, it's called a zero-cost collar. This is popular because there's no upfront cash outlay, but the borrower gives up the benefit of rates falling below the floor.

**Exam tip:** The CFA exam frequently asks which instrument a floating-rate borrower should use. Remember: borrowers buy caps (or collars) to protect against rising rates. Lenders buy floors to protect against falling rates. A collar gives up some downside benefit in exchange for a cheaper cap.

Practice more interest rate derivatives in our CFA Level II question bank on AcadiFi.

How do interest rate caps, floors, and collars work for hedging floating-rate debt?

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Practice Questions

SOFR	Cap Payoff	Floor Payoff	Net Position	Effective Rate (+ 150bps)
3.00%	$0	-$125,000 (pay out)	Floor limits downside benefit	5.00%
3.50%	$0	$0	No payoffs	5.00%
4.50%	$0	$0	No payoffs	6.00%
5.50%	$0	$0	At cap strike	7.00%
6.50%	+$250,000	$0	Cap limits upside cost	7.00%