How do I construct an interest rate collar to hedge a floating-rate loan?

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AcadiFi · Accepted Answer

A collar combines a purchased cap with a sold floor — the sold floor's premium partially or fully offsets the cap premium, creating a corridor of acceptable rates. Structure for your $50M 5Y floating loan at SOFR + 200bps: - Buy 4.50% cap on SOFR (strike above current 4.00% SOFR) — cost say 85bps running. - Sell 3.00% floor on SOFR (strike below current SOFR) — receive say 35bps running. - Net cost: 50bps running. Effective borrowing behavior: - If SOFR > 4.50%: cap pays, capping your all-in rate at 6.50% (cap strike + 200bps spread). - If 3.00% < SOFR < 4.50%: neither option pays, you float with the market. - If SOFR < 3.00%: you pay the floor holder, floor strike + 200bps = 5.00% all-in minimum. Zero-cost collar: adjust strikes so cap premium = floor premium, eliminating upfront cost. Set 4.75% cap and 3.25% floor, for instance. ```mermaid flowchart TD A[Floating Loan] --> B[Buy Cap 4.50%] A --> C[Sell Floor 3.00%] B --> D[Protected Above 4.50%] C --> E[Give Up Below 3.00%] ``` Collars are popular because corporate treasurers resist paying large upfront premiums — sacrificing some downside benefit is acceptable in exchange for cheaper insurance.

How do I construct an interest rate collar to hedge a floating-rate loan?

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