Use of Derivatives for Interest Rate Risk Management
Interest Rate Collars
This instrument combines in one agreement an interest rate cap and an interest rate floor. The collars' purchaser pays a premium for the rate cap while receiving a premium for accepting the rate floor. The net premium paid for the collar can be positive or negative, depending upon the outlook for interest rates and the risk aversion of the borrower and the lender at the time of the agreement. Banks can use collars to protect their earnings when interest rate appear to be unusually volatile and there is considerable insecurity about the direction in which market interest rates may move. The other added advantage of an Interest Rate Collar is the fact that the premium to be paid for the interest rate cap is raised through the floor, thus making this derivative an extremely cost effective mechanism of hedging interest rate exposure.
Also read about :
Interest Rate Caps
Interest Rate Floors