How does an interest rate collar work for a floating-rate borrower?

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AcadiFi · Accepted Answer

A collar combines a long cap (protection against rising rates) with a short floor (giving up benefit of falling rates). The floor premium offsets the cap premium, often producing a zero-cost collar. Scenario: Norfield Manufacturing has a $60M 5-year floating-rate loan at SOFR + 150 bps. Current SOFR = 4.8%. Norfield buys a 6% cap (pays when SOFR > 6%) for 120 bps upfront, and sells a 3.5% floor (must pay counterparty when SOFR < 3.5%) for 120 bps upfront. Net cost = 0. Effective rate range: - If SOFR between 3.5% and 6%, Norfield's cost is SOFR + 1.5% (unchanged). - If SOFR > 6%, cap caps SOFR component at 6%, so cost = 7.5% max. - If SOFR < 3.5%, floor forces Norfield to pay counterparty difference, floor-adjusted rate = 3.5% + 1.5% = 5% min. ```mermaid graph LR A[Floating debt
SOFR+150] --> B[Long 6% cap] A --> C[Short 3.5% floor] B --> D[Max rate 7.5%] C --> E[Min rate 5.0%] D --> F[Effective band] E --> F ``` Trade-off: Norfield gives up benefit below 3.5% to fund the cap. Zero-cost collars are popular because they appear free on the P&L, but they embed opportunity cost if rates fall. A CFA nuance: the collar's value is not zero - only its initial premium is. As rates move, MTM of cap and floor diverge. Related: an 'interest rate corridor' = long cap at K1 + short cap at K2 (K2 > K1), a cheaper but partial hedge.

How does an interest rate collar work for a floating-rate borrower?

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