Question

A Financial Institution make the following collar

$100 million cap of 8 percent at a premium of 0.45 percent of face value.

$100 million floor of 5 percent at a premium of 0.30 percent of face value.

a) What happens if interest rate are 9.5%?

b) What happens if interest rate are 4.25%?

Answer 1

Cost for buying the Cap = 100 mm * 0.45% = 450,000

Cost of buying the Floor = 100 mm * 0.30% = 300,000

Total cost of the Collar = 450,000 + 300,000 = 750,000

a) If interest rate rises to 9.5%, only cap will be exercised and the gain on Cap will be:

= 100 mm * (9.5% - 8%)

= 100 mm * 1.5%

= 1,500,000

P&L on Collar = Gain on Cap - Total Cost of Collar

= 1,500,000 - 750,000

= 750,000 is the answer

b) If interest rate falls to 4.25%, only Floor will be exercised and the gain on Floor will be:

= 100 mm * (5% - 4.25%)

= 100 mm * 0.75%

= 750,000

P&L on Collar = Gain on Floor - Total Cost of Collar

= 750,000 - 750,000

= 0 i.e no profit no loss is the answer