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Financial Management · Hedging techniques for interest rate risk

Interest Rate Options, Caps, Floors and Collars Explained

Updated 11 October 2026 · Fact-checked

An interest rate option gives you the right, but not the obligation, to fix a borrowing or deposit rate. A borrower pays a premium and exercises only if rates rise above the strike. Caps, floors and collars are series of such options. Compare the market rate with the strike, then add the premium.

Understand Interest Rate Options and Caps, Floors, Collars

An interest rate option protects you against a bad move in rates but lets you keep the benefit of a good move. You pay a premium up front for this. A forward rate agreement or a future locks you in. An option does not.

There are two types. An OTC option (also called an interest rate guarantee) is bought from a bank. It is tailored to your loan amount, dates and strike rate. The premium is quoted as a percentage of the loan. An exchange-traded option is an option on an interest rate future. It has standard contract sizes and expiry dates. The premium is quoted in price points.

A borrower fears rising rates. So a borrower buys an OTC interest rate guarantee (a call option on the interest rate) or, on an exchange, a put option on a future. Futures prices are quoted as 100 minus the interest rate. When rates rise, futures prices fall, so a put gains value. A depositor fears falling rates and does the opposite.

A cap is a series of interest rate options that sets a maximum rate on floating-rate borrowing. A floor sets a minimum rate for a lender or depositor. A collar combines the two. A borrower buys a cap and sells a floor. The premium received on the floor reduces the cost of the cap. The cost of the cheaper protection is that the borrower gives up the benefit of rates falling below the floor.

The exercise decision is simple. Exercise only if it leaves you better off than the market. For a borrower, that means the market rate is above the strike rate. If it is not, let the option lapse and borrow at the market rate. The premium is a sunk cost either way.

Key rules to remember

Futures price and rate
Futures price = 100 − interest rate (%)
A strike price of 94.50 means a strike rate of 5.50%.
Number of contracts
Contracts = Loan ÷ Contract size × Loan period ÷ Contract period
Round to the nearest whole contract. Use the same time units for both periods.
Tick value
Tick value = Contract size × 0.01% × Contract months ÷ 12
For a 1,000,000 three-month contract, one tick (0.01) is worth 25.
Exchange-traded option exercise rule (borrower)
Exercise the put if futures price at expiry < strike price
Gain per contract = (strike price − futures price) ÷ 0.01 × tick value. Dividing the price difference by 0.01 converts points to ticks. For example, 1.50 ÷ 0.01 = 150 ticks × $25 = $3,750.
OTC option premium
Premium = Loan × premium % (not annualised)
Payable up front. If the question says so, compound it to the end of the loan at the market rate. That means from the date you pay it, including any months before the loan starts.
Effective rate if exercised
Effective rate = Strike rate + premium cost expressed as an annual rate
For an exchange-traded premium quoted in points, the premium adds that many points to the annual rate.
Effective rate if not exercised
Effective rate = Market rate + premium cost
The option lapses and you borrow at the market rate.
Collar (borrower)
Net premium = Cap premium paid − Floor premium received
Rate paid lies between the floor rate and the cap rate, adjusted for net premium.

How to solve Interest Rate Options and Caps, Floors, Collars questions

Use this order for any option, cap, floor or collar question. It works for borrowers and for depositors.

  1. 1Identify who you are and the risk. A borrower fears rising rates. A depositor fears falling rates. This decides whether you need a cap-type or floor-type position.
  2. 2Choose the instrument. For an exchange-traded option, a borrower buys puts on futures and a depositor buys calls. For an OTC option, use the guaranteed strike rate.
  3. 3Work out the size. For exchange-traded options, calculate the number of contracts using the loan amount and the period. Round to a whole number.
  4. 4Compare the outcome rate with the strike. For a borrower, exercise if the market rate at expiry is above the strike rate, or if the futures price is below the strike price.
  5. 5Calculate the gain or the cost. If exercised, interest is at the strike rate (OTC) or the loan interest less the option gain (exchange-traded). If lapsed, interest is at the market rate.
  6. 6Add the premium. For OTC, it is a percentage of the loan. For exchange-traded, it is points × tick value × contracts. Compound it only if the question tells you to.
  7. 7State the net cost and the effective annual rate. Divide total cost by the loan, then annualise.
  8. 8Add a comment if asked. Mention the premium, the flexibility, and how the option differs from a future or an FRA.

Quickest way: Strike versus market, then premium

When to use it: Use this for OT cases and for the first part of a Section C answer when you only need the effective rate.

  1. Convert everything to a rate. Futures price 100 − price gives the rate.
  2. Borrower: effective rate = lower of the strike rate and the market rate, plus the premium in rate terms.
  3. Depositor: effective rate = higher of the strike rate and the market rate, minus the premium in rate terms.
  4. For an exchange-traded option quoted in points, add the premium points directly to the rate. 0.30 points adds 0.30% a year.
  5. For an OTC premium quoted as a percentage of the loan, convert to a yearly rate by multiplying by 12 and dividing by the loan months. A 0.4% premium on a 6-month loan adds 0.8% a year before any compounding. If the question tells you to compound the premium, the effect is slightly higher. In the first worked example, compounding over nine months adds about 0.84% a year at a 6.5% market rate and about 0.82% at a 4% market rate.
  6. Check with a cash calculation only if the question asks for an amount.

Common mistakes in Interest Rate Options and Caps, Floors, Collars

  • Buying a call on futures when you are a borrower

    Students think a borrower needs a call because rates are going up.

    Fix: Futures prices fall when rates rise. A borrower needs the price to be able to fall, so buy a put. Say it as: rates up, price down, put.

  • Forgetting the premium in the net cost

    The exercise decision feels like the whole answer.

    Fix: Always add the premium to the cost, even when the option lapses. The premium is paid in every scenario.

  • Comparing the strike price with the market interest rate

    Futures use prices, loans use rates, and students mix them.

    Fix: Convert first. Compare price with price or rate with rate, never one with the other.

  • Using the wrong number of contracts

    The time adjustment is skipped, or the loan period and contract period are in different units.

    Fix: Contracts = loan ÷ contract size × loan months ÷ contract months. Write both periods in months.

  • Treating the premium on an OTC option as an annual rate

    The premium is shown as a percentage, so it looks like a yearly figure.

    Fix: An OTC premium is a percentage of the loan, paid once. Calculate the cash amount first. Then annualise it if you need an effective rate.

  • Getting the collar premiums the wrong way round

    Students forget that the borrower sells the floor.

    Fix: The borrower pays the cap premium and receives the floor premium. Net premium is cap minus floor. The saving comes at the cost of losing gains below the floor.

Worked examples

Example 1

A company will borrow $20 million for six months starting in three months. The loan interest rate will be the market rate at that date. The company buys an OTC interest rate guarantee with a strike of 5% and a premium of 0.4% of the loan, payable now. Show the total six-month cost (interest plus premium) and the effective annual rate if the market rate in three months is (a) 6.5% and (b) 4%. Compound the premium over the full nine months to the end of the loan (three months before the loan starts plus the six-month loan), using the market rate that applies in each case.

Show the solution
  1. Premium = $20,000,000 × 0.4% = $80,000.
  2. (a) Market rate 6.5% is above the 5% strike, so exercise. Interest = $20,000,000 × 5% × 6/12 = $500,000.
  3. (a) Premium compounded over nine months = $80,000 × (1 + 0.065 × 9/12) = $80,000 × 1.04875 = $83,900.
  4. (a) Total cost = $500,000 + $83,900 = $583,900. Effective annual rate = 583,900 ÷ 20,000,000 × 2 = 5.839%, about 5.84%. This is an approximation, because the cost is spread over the six-month loan only.
  5. (b) Market rate 4% is below the 5% strike, so let the option lapse and borrow at 4%. Interest = $20,000,000 × 4% × 6/12 = $400,000.
  6. (b) Premium compounded over nine months = $80,000 × (1 + 0.04 × 9/12) = $80,000 × 1.03 = $82,400.
  7. (b) Total cost = $400,000 + $82,400 = $482,400. Effective annual rate = 482,400 ÷ 20,000,000 × 2 = 4.824%, about 4.82%.

Answer: With the premium compounded over the full nine months: (a) Exercise: total cost $583,900, effective rate about 5.84%. (b) Lapse: total cost $482,400, effective rate about 4.82%.

Example 2

A company will borrow $9 million for three months starting in four months. It uses three-month futures options with a contract size of $1,000,000. Assume the options expire at the start of the loan, in four months. It buys put options with a strike price of 94.50 and a premium of 0.30 points. At expiry the futures price is 93.00 if rates rise to 7%, or 95.50 if rates fall to 4.5%. Assume the futures price at expiry equals 100 minus the market rate. Calculate the net cost and effective annual rate in each case. Ignore the financing of the premium.

Show the solution
  1. Contracts = $9,000,000 ÷ $1,000,000 × 3 ÷ 3 = 9.
  2. Tick value = $1,000,000 × 0.01% × 3/12 = $25.
  3. Premium = 0.30 points = 30 ticks × $25 = $750 per contract. For 9 contracts = $6,750.
  4. Rates rise to 7%: futures price 93.00 is below the 94.50 strike, so exercise. Gain = (94.50 − 93.00) ÷ 0.01 = 150 ticks × $25 = $3,750 per contract. For 9 contracts = $33,750.
  5. Loan interest = $9,000,000 × 7% × 3/12 = $157,500.
  6. Net cost = $157,500 − $33,750 + $6,750 = $130,500. Effective annual rate = 130,500 ÷ 9,000,000 × 4 = 5.8%. This equals the 5.50% strike rate plus 0.30 premium points.
  7. Rates fall to 4.5%: futures price 95.50 is above the 94.50 strike, so let the option lapse. Loan interest = $9,000,000 × 4.5% × 3/12 = $101,250.
  8. Net cost = $101,250 + $6,750 = $108,000. Effective annual rate = 108,000 ÷ 9,000,000 × 4 = 4.8%. This equals the 4.5% market rate plus 0.30 premium points.

Answer: Rates at 7%: exercise, net cost $130,500, effective rate 5.8%. Rates at 4.5%: lapse, net cost $108,000, effective rate 4.8%.

Exam tips

  • Look at the verb in the question. If it asks you to recommend or compare, add a short comment on cost, flexibility and certainty after the numbers.
  • In OT questions, the trap is often put versus call, or price versus rate. Convert to one basis before you choose.
  • State clearly whether you exercise or let the option lapse, and give the reason in one line. Markers look for the decision.
  • For a collar, show the cap premium, the floor premium and the net premium as separate lines. Then state the range of rates the company will pay.
  • When asked to compare options with futures or FRAs, make three points: options give the right and not the obligation, they cost a premium, and they leave the upside open.

Practice questions from Hedging techniques for interest rate risk

Interest Rate Options and Caps, Floors, Collars in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Interest Rate Options and Caps, Floors, Collars: frequently asked questions

What is the difference between interest rate options and futures?

A future is an obligation. It locks in a rate, so you gain or lose whichever way rates move. An option is a right. You pay a premium up front and exercise only if it helps, so you keep the benefit of favourable moves.

How do I decide whether to exercise an interest rate option?

Compare the market outcome with the strike. A borrower exercises if the market rate is above the strike rate, or if the futures price is below the strike price. If not, the option lapses and the borrower pays the market rate.

What is the difference between a cap, a floor and a collar?

A cap sets a maximum rate for a borrower. A floor sets a minimum rate for a lender or depositor. A collar combines the two. A borrower buys a cap and sells a floor, so the floor premium offsets some of the cap cost.

Why does a borrower buy put options on futures?

Futures prices are 100 minus the interest rate. When rates rise, futures prices fall. A put option gains when the price falls, so it offsets the higher interest cost on the loan.

Do I add the premium if the option lapses?

Yes. The premium is paid up front whether or not you exercise. Always include it in the total cost and the effective rate.