Question

Explain why a BigCorp with a bank loan on which it pays LIBOR might use an interest rate collar (on LIBOR). Include in a table, the payoff and profit from the collar and draw a diagram of the payoff for different outturn values for LIBOR.

Answer 1

Let the upper threshold of collar (ie strike price of call option) = 3%

Let the lower threshold of collar (ie strike price of put option) = 2%

If LIBOR rises above 3%, then BigCorp will pay only 3%

If LIBOR falls above 2%, then BigCorp will pay only 2%

For any rate between 2%&3%, that rate is paid

LIBOR	LIBOR Paid	Pay-off	Remarks
0.5%	2%	0.5%-2% = -1.5%	LIBOR is below the lower threshold of 2%
1.0%	2%	1%-2% = -1.0%	LIBOR is below the lower threshold of 2%
1.5%	2%	1.5%-2% = -0.5%	LIBOR is below the lower threshold of 2%
2%	2%	2%-2% = 0%
2.5%	2.5%	2.5%-2.5% = 0%
3.0%	3.0%	3%-3.0% = 0%
3.5%	3.0%	3.5%-3.0% = 0.5%	LIBOR is above the upper threshold of 3%
4.0%	3.0%	4.0%-3.0% = 1.0%	LIBOR is above the upper threshold of 3%
4.5%	3.0%	4.5%-3% = 1.5%	LIBOR is above the upper threshold of 3%