What is done is to establish upper and lower limits. In this way, we prevent the interest rate from rising above a maximum (harmful to the borrower) or falling below a minimum (harmful to the lender). Thus, I will obtain a profit or a loss.
Although we will see a detailed example, let’s imagine a variable interest loan in which we contract a maximum rate for which I will pay a premium. In turn, we benefit from a minimum rate for which we will be paid.
Cap and Floor in the collar (finance)
Let’s see how this type of collar loan works:
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- The first step is to know what our limits are going to be. That is, what will be the highest and lowest interest rate.
- Next, we contract a cap (ceiling), for which we will pay a premium, and which is nothing more than that maximum level that we can afford. If rates go above that, we’ll get paid.
- We can also hire a floor or minimum level. In this case it works the other way around, we are the ones who pay if the rate falls below this. Only in this case we receive a premium.
- Finally, we calculate the cost for the borrower, that is, for us, which we will see next.
Calculation of the cost for the borrower
The calculation is very simple. Once the loan operations are carried out, you only have to take into account the premiums paid and collected, as well as the net interest to be paid, which is obtained by taking into account the collections or payments of the cap and floor. The cost to the borrower will include net interest and premiums.
These premiums serve to offset increases and decreases in rates. So if it goes above the upper limit, we charge it to compensate the borrower (us), if it goes below, we pay the lender. Of course, we will not benefit from this rate cut.
Necklace example (finance)
Let’s see a simple operation. Imagine a company that asks for a loan of 1 million dollars ($) for 5 years. The rate to be paid coincides with a reference rate, for example, that of the Federal Reserve System (FED). Let’s imagine that it is at 2.5% at the time of signing.
As the company does not want the interest to rise above 3.5%, it contracts a cap for which it pays a premium of $5,000. In addition, he sells a floor of a minimum of 1.5% for which he charges a premium of $1,000. Let’s see what a loan table would look like.
We can see, first of all, the conditions of the operation. Then, the table shows the years, the interest rates for each year and whether it is charged (cap) or paid (floor), in cases where the interest rises or falls below the established limits. The values of the ceiling and floor are calculated by the difference between the contracted interest rate and the cash multiplied by the loan.
We see that this type of operation, collar (finance), allows us to calculate the total cost for the borrower ($134,000). This will be the net interest of adding or subtracting the cap and floor values to the gross interest, as well as the difference between the premium paid ($5,000) and the premium collected ($1,000).