Interest rate cap (CAP)
A company that would like to eliminate the risk due to rising rates can purchase a cap, which provides an upper limit on their floating rate loan. The agreement means that the client pays the market rate as long as it is below the cap, but pays a fixed rate if it is above the cap.
Interest rate floor (FLOOR)
A company that invests funds can take advantage of purchasing an interest rate option to ensure a minimum return on the investment. The company takes precautions against the market rate falling below a certain level, as well as taking advantage of rising market rates.
Interest rate collar (COLLAR)
An interest rate collar means that the company purchases a cap and sells a floor. The aim of this is to hedge against the market rate exceeding the interest rate cap, while being willing to refrain from the market rate below the interest rate floor. In practice, this means that the rates follow market rates, but are limited by both the interest rate cap and the interest rate floor. The advantage of an interest rate floor is a lower option premium, but the disadvantage is that the client cannot take advantage of a fall in interest rates below the interest rate floor.
A client who purchases an interest rate option must pay, upon entering into the agreement, an option premium determined based on market expectations, the maturity of the option and the current interest rate level. DNB Markets offers options in most currencies, for periods of up to 10 years.