Collar (finance)

In finance, a collar is an option strategy that limits the range of possible positive or negative returns on an underlying to a specific range.

Equity collar

Structure

A collar is created by:[1]

These latter two are a short risk reversal position. So:

Underlying − risk reversal = Collar

The premium income from selling the call reduces the cost of purchasing the put. The amount saved depends on the strike price of the two options.

Most commonly, the two strikes are roughly equal distances from the current price. For example, an investor would insure against loss more than 20% in return for giving up gain more than 20%. In this case the cost of the two options should be roughly equal. In case the premiums are exactly equal, this may be called a zero-cost collar; the return is the same as if no collar was applied, provided that the ending price is between the two strikes.

On expiry the value (but not the profit) of the collar will be:

Example

Consider an investor who owns one hundred shares of a stock with a current share price of $5. An investor could construct a collar by buying one put with a strike price of $3 and selling one call with a strike price of $7. The collar would ensure that the gain on the portfolio will be no higher than $2 and the loss will be no worse than $2 (before deducting the net cost of the put option; i.e., the cost of the put option less what is received for selling the call option).

There are three possible scenarios when the options expire:

One source of risk is counterparty risk. If the stock price expires below the $3 floor then the counterparty may default on the put contract, thus creating the potential for losses up to the full value of the stock (plus fees).

Interest Rate Collar

Structure

In an interest rate collar, the investor seeks to limit exposure to changing interest rates and at the same time lower its net premium obligations. Hence, the investor goes long on the cap (floor) that will save it money for a strike of X +(-) S1 but at the same time shorts a floor (cap) for a strike of X +(-) S2 so that the premium of one at least partially offsets the premium of the other. Here S1 is the maximum tolerable unfavorable change in payable interest rate and S2 is the maximum benefit of a favorable move in interest rates.[2]

Example

Consider an investor A who has an obligation to pay floating 6 month LIBOR annually on a notional N and which (when invested) earns 6%. A rise in LIBOR above 6% will hurt the investor while a drop will benefit her. Thus it is desirable for her to purchase an interest rate cap which will pay her back if the LIBOR rises above her level of comfort. Figuring that she is comfortable paying up to 7%, she enters into an Interest Rate Cap with counterparty B wherein B will pay her the difference between 6 mo LIBOR and 7% when the LIBOR exceeds 7% for a premium of 0.08*N. To offset this premium, she sells an Interest Rate Floor to counterparty C wherein she will pay them the difference between 6 mo LIBOR and 5% when the LIBOR falls below 5%. For this she receives 0.075*N premium, thus offsetting what she paid for the Cap.[3]

Now she can face 3 scenarios:

  1. Rising interest rates - she will pay a maximum of 7% on her original obligation. Anything over and above that will be offset by the payments she will receive from party B under the Cap agreement. Hence A is not exposed to interest rate rises of more than 1%.
  2. Stationary interest rates - as long as the LIBOR stays around 6%, A is not affected.
  3. Falling interest rates - she will benefit from a fall in interest rates up to a limit of 5% as per the floor agreement. If it falls further, A will make payments to C under the Floor agreement while saving the same amount on the original obligation. Hence A cannot benefit from a fall of more than 1%.

Rationale

In times of high volatility, or in bear markets, it can be useful to limit the downside risk to a portfolio. One obvious way to do this is to sell the stock. In the above example, if an investor just sold the stock, the investor would get $5. This may be fine, but it poses additional questions. Does the investor have an acceptable investment available to put the money from the sale into? What are the transaction costs associated with liquidating the portfolio? Would the investor rather just hold on to the stock? What are the tax consequences?

If it makes more sense to hold on to the stock (or other underlying asset), the investor can limit that downside risk that lies below the strike price on the put in exchange for giving up the upside above the strike price on the call. Another advantage is that the cost of setting up a collar is (usually) free or nearly free. The price received for selling the call is used to buy the put—one pays for the other.

Finally, using a collar strategy takes the return from the probable to the definite. That is, when an investor owns a stock (or another underlying asset) and has an expected return, that expected return is only the mean of the distribution of possible returns, weighted by their probability. The investor may get a higher or lower return. When an investor who owns a stock (or other underlying asset) uses a collar strategy, the investor knows that the return can be no higher than the return defined by strike price on the call, and no lower than the return that results from the strike price of the put.

Symmetric Collar

A symmetric collar is one where the initial value of each leg is equal. The product has therefore no cost to enter.

References

  1. ↑ "Statement 133 Implementation Issue No. E18". Retrieved July 8, 2011.
  2. ↑ HM Revenues and Customs. "CFM13350 - Understanding corporate finance: derivative contracts: interest rate collars: Using interest rate collars". Retrieved July 8, 2011.
  3. ↑ "Interest Rate Collars". Investopedia. Retrieved July 8, 2011.
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