In this blog, I want to cover a topic that is part of Interest Rate Risk Hedging within the ACCA AFM syllabus. In particular, to ensure that you don’t make a common error made by many students.
The collar hedge has a very clear purpose. It is designed to protect the company from an adverse change in interest rates, but allow them to participate,to some extent, in a beneficial movement in rates.
So if we planning to take out a short term loan finance, the rise in interbank rates (as used in ACCA AFM questions) will hurt the company. The company can counteract this by setting up a ceiling rate using a Put option. The ceiling rate is simply computed as 100 – Put Option Rate/Price.
The company has to pay a premium for this (no such thing as a free lunch 😀). But, the company has insured itself against any adverse rate change in the futures interest rate/price.
Remember, if the interbank rate rises it will cause the futures interest rate to rise & the futures price to fall. I prefer to use the former rather than the latter.
But, that premium is a problem. The company will want to pay less. It could raise the ceiling rate & this will save premium. However, it’s hedge is less effective.
The solution is to set up a collar. It keeps the Put option & the ceiling rate. But, the company will simultaneously sell a Call Option. This sets up a floor rate at 100 – Call Option rate/price.
It will receive a premium on the Call Option which it can net off on the premium paid on the Put Option. The net value may even be positive !
Now, if the interbank rate causes the futures rate to go above the ceiling value,the company will claim on their Put Option. But, vice versa will lead to the company paying out on the Call Option they have sold.
In essence, the company has protected itself from an adverse change in rates, but can only take limited benefit from a beneficial change in exchange for saving premium.
Collars can also be set up for investments (Buy a Call & Sell a Put).
So what’s the common student error you may ask ? Well, students often set the ceiling rate lower than the floor. For example
Ceiling at 5.25 (94.75)
Floor at 5.75 (94.25)
Now, as I say when I see this “Only Lionel Richie can Dance on the Ceiling” (Google him). You are not Lionel Richie 🤣”.