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Chapter 11

5.3 Caps, floors and collars

 A borrower will hedge against the risk of interest rate rises by
buying a put option (or cap) over interest rate futures.

 A depositer will hedge against the risk of interest rate falls by
buying a call option (or floor) over interest rate futures.

 A collar is a combination of a cap and a floor. The company buys
one and sells the other, at a different exercise price:

Borrower buy put (cap) sell call (floor)

Depositer buy call (floor) sell put (cap)

For example, for a borrower:

Protects company

Buy put at
90.00 i.e.
cap at 10%

Sell call at
92.00 i.e.
floor is 8% Benefits counterparty

Time

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