Collar Options
Zero Premium
Collar options are structured options that provide you with a known worst-case rate (known as the protection rate) and a best-case rate (known as the collar rate), which you can use to transact on a given date in the future. You are able to participate in favourable movements in the spot rate between the participation and collar rates.
Collar options are generally structured as zero-premium products, but they can be structured with a premium in order to help you achieve more favourable terms from the outset.
How do collar options work?
For importers, collar options are structured by entering into two concurrent options:
- In the first, you purchase a put option from Currency Hedger, giving you the right, but not the obligation, to sell the notional amount to Currency Hedger at the protection rate
- In the second, you sell a call option to Currency Hedger at the protection rate, which will oblige you to transact the notional amount at the collar rate, should the spot rate be more favourable than that rate at the expiration time and date.
Collar options example:
A UK-based company imports materials from the US and needs to pay a supplier $500,000 in six months’ time.
1. Requirements
The company: would like to benefit from a favourable exchange rate and 100% rate protection is willing to pay a premium for this
2. Current Forward Rate
The forward rate for a six-month period is 1.3200
3. Solution
The company is prepared to accept a protected rate of 1.3000. The company buys a collar with a protected rate of 1.3000 and a best-case rate of 1.3650
There are three possible scenarios
Scenario 1:
Unfavourable market moves
GBP/USD weakens. At maturity, the exchange rate is 1.2700. The company is entitled to buy the full $500,000 at 1.3000.
Scenario 2:
Favourable market moves – in-between the protected rate and best-case rate
GBP/USD strengthens. The exchange rate at maturity is 1.3600, which is in-between the protected rate and best-case rate. The company is entitled to buy dollars in the spot market at 1.3600.
Scenario 3:
Favourable market moves, above the best-case rate
GBP/USD strengthens. On expiry, it is trading at 1.3800, which is above the company’s best-case rate. The company is obliged to purchase dollars at 1.3650.
Advantages of collar options
- Collar options are generally structured as zero-premium.
- They guarantee protection at a known worst-case rate (protection rate).
- They give you the ability to participate in favourable exchange rate movements, as far as the collar rate.
- Collar options offer a slightly more favourable mark-to-market profile than the equivalent forward contract.
Disadvantages of collar options
- Participation in favourable exchange rate movements is capped at the collar rate, meaning that you will not be able to benefit in all favourable movements in the spot rate.
- Collar options are subject to a variation margin. If the spot rate moves significantly prior to expiry, Currency Hedger may ask you to pay a deposit (also known as a margin call)
- The protection rate is less favourable than the equivalent forward contract.
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