Advanced Financial Management · The use of financial derivatives to hedge against interest rate risk

Interest Rate Options, Caps, Floors and Collars in AFM

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 at a strike level for a premium. To solve a question, compare the market rate with the strike, decide whether to exercise, then add the premium to get the effective rate. A collar adds a sold option to cut the premium.

Understand Interest Rate Options and Collars

An interest rate option protects you against a bad move in interest rates but lets you keep a good move. You pay a premium up front. In return you get the right to deal at a fixed strike rate. If the market rate is better than the strike, you let the option lapse and use the market. The premium is gone either way.

There are two routes. OTC options are bought from a bank and tailored to your amount, dates and strike. An OTC option on a single loan period is often called an interest rate guarantee (IRG). Exchange-traded options are options on interest rate futures. They come in standard contract sizes and dates, and you must round the number of contracts.

A cap is a series of options that sets a maximum rate on floating-rate borrowing. A borrower buys a cap. A floor sets a minimum rate. A lender or depositor buys a floor to protect its income. A collar combines the two. A borrower buys a cap and sells a floor. The premium received on the floor reduces the premium paid on the cap. The cost of this saving is that you give up the benefit of rates falling below the floor.

For exchange-traded options, the futures price is 100 minus the interest rate. When rates rise, futures prices fall. A borrower who fears a rise therefore buys put options on futures. A lender who fears a fall buys call options on futures. The option is exercised only if it is in the money at expiry. In exam questions, premiums are normally quoted as a percentage per year, so you must scale them for the period.

You only need to know two things for every outcome: what you pay or receive on the loan, and what the option contributes. Do this for a high-rate and a low-rate scenario. That shows how the hedge limits your risk.

Key rules to remember

Futures price: Futures price = 100 − interest rate (%); A rate of 4.6% is a futures price of 95.40. Use this to convert strike prices to rates.
Tick value: Tick value = contract size × 0.01% × (months ÷ 12); For a $1,000,000 three-month contract: 1,000,000 × 0.0001 × 3/12 = $25.
Number of contracts: Contracts = loan ÷ contract size × (loan months ÷ contract months); Round to a whole number. The exam usually states the contract size and period.
Exchange-traded borrower hedge: Buy put options. Exercise if futures price at expiry < strike price. Gain = (strike − futures price) in ticks × tick value; A lender or depositor buys calls and exercises if the futures price is above the strike.
Effective rate (OTC cap): If market rate > strike: strike + annualised premium. If market rate ≤ strike: market rate + annualised premium; Annualised premium = flat premium % × 12 ÷ number of months in the period. This ignores the time value of the premium.
Effective rate (exchange-traded put): Effective rate = (100 − strike price) + premium, if exercised; Premium is in annual percentage points. For a 3-month loan, strike of 95.50 and premium 0.30 gives 4.50% + 0.30% = 4.80%.
Collar: Net premium = cap premium paid − floor premium received. Rate paid is capped at cap rate and floored at floor rate, then add net premium; A borrower buys the cap and sells the floor. Between the two strikes you pay the market rate.

How to solve Interest Rate Options and Collars questions

Use this method for any option or collar question, OTC or exchange-traded.

1Identify who you are: borrower (fears rising rates) or lender (fears falling rates). This decides cap or put (borrower) versus floor or call (lender).
2Note the exposure: amount, start date, length of the period and floating or fixed basis. For exchange-traded options, work out the number of contracts and the tick value.
3Choose the instrument and the strike. Convert futures strike prices to rates using 100 minus the price.
4Calculate the premium for the period and the annualised premium. State your assumption if you ignore the time value of the premium.
5For each rate scenario, decide whether the option is exercised. Compare the market rate (or futures price) with the strike.
6Calculate the net result for each scenario. Show the interest paid, the option gain or loss and the premium. Then work out the effective rate.
7For a collar, repeat step 5 for both the cap and the floor. Use the net premium and state the minimum and maximum rate.
8Comment briefly: compare with an FRA or swap, note the flexibility versus premium cost, and note basis risk or mismatch for exchange-traded options.

Quickest way: Effective rate shortcut

When to use it: Use when the question asks for the effective rate or the cost of the hedge at several interest rates, and the option is a simple cap, IRG or put on futures.

Find the worst rate you can pay: strike rate plus annualised premium.
Find the break-even: the market rate at which the option is not worth exercising is the strike. Above the strike, you pay strike plus premium. At or below it, you pay market plus premium.
Write the answer for each scenario in one line: rate paid = lower of market and strike, plus premium.
For a collar, use: rate paid = market rate limited to between floor and cap, plus net premium.
Only do the full dollar calculation if the question asks for amounts. Then multiply the rate by the loan and by the fraction of the year.

Common mistakes in Interest Rate Options and Collars

Forgetting the premium in the effective rate, or forgetting it when the option lapses.
Students focus on the exercise decision and treat the premium as a side issue.
Fix: Always add the premium to the result, whether or not you exercise. It is a sunk cost paid on day one.
Using the wrong option type on futures: buying calls when the borrower needs puts.
The link between rate rises and falling futures prices is not applied.
Fix: Futures price = 100 − rate. Rates up means price down. A borrower profits from a price fall, so buys puts.
Applying the annual premium to the full period without scaling, or mis-scaling the flat premium.
Exchange-traded premiums are in annual percentage points, but OTC premiums are often quoted flat on the principal.
Fix: Check how the premium is quoted. Annual points: scale by months ÷ 12 for dollars. Flat on the principal: multiply by 12 ÷ months to annualise.
Getting the number of contracts wrong or not rounding.
The loan period differs from the contract period and students forget the time adjustment.
Fix: Use loan ÷ contract size × loan months ÷ contract months. Round to a whole number and comment on any under- or over-hedge.
Describing a collar as free or as guaranteeing the best outcome.
Premium income from the floor is mistaken for no cost.
Fix: A collar reduces the premium but removes the benefit of rates falling below the floor. In some cases the premium can net to zero, but you still give up that gain.
Exercising an option that is out of the money, or comparing the market rate with the wrong side of the strike.
Direction is not checked in each scenario.
Fix: Borrower with a cap: exercise only if the market rate is above the strike. Lender with a floor: exercise only if the market rate is below the strike.

Worked examples

Example 1

A company will borrow $20 million for 6 months at a floating rate starting immediately after the reset date. It can buy an OTC cap at a strike of 5% for a premium of 0.40% of the principal (flat, for the 6-month period). It can also sell a floor at 3.5% and receive 0.25% of the principal. (a) Find the effective annual rate with the cap alone if the market rate is 6.5% or 4%. (b) Find the effective annual rate with the collar if the market rate is 6.5%, 4% or 3%. Ignore the time value of the premiums.

Show the solution

Annualise the cap premium: 0.40% × 12 ÷ 6 = 0.80%.
(a) Rate 6.5%: the market is above 5%, so exercise the cap. Interest is 20,000,000 × 5% × 6/12 = $500,000. Premium is 20,000,000 × 0.40% = $80,000. Total is $580,000. Effective rate = 580,000 ÷ 20,000,000 × 2 = 5.8%.
(a) Rate 4%: the market is below 5%, so let the cap lapse. Interest is 20,000,000 × 4% × 6/12 = $400,000. Add the premium of $80,000. Total is $480,000. Effective rate = 4.8%.
(b) Net premium = 0.40% − 0.25% = 0.15% flat, or $30,000. Annualised this is 0.15% × 2 = 0.30%.
(b) Rate 6.5%: cap exercised, floor not. Rate paid is 5% + 0.30% = 5.30%.
(b) Rate 4%: between 3.5% and 5%, so neither option is exercised. Rate paid is 4% + 0.30% = 4.30%.
(b) Rate 3%: the market is below the floor, so the floor is exercised against the company. Rate paid is 3.5% + 0.30% = 3.80%.
Comment: the collar lowers the cost, but the company loses the benefit of rates falling below 3.5%.

Answer: (a) Cap only: 5.8% at 6.5% market rate; 4.8% at 4%. (b) Collar: 5.30% at 6.5%; 4.30% at 4%; 3.80% at 3%. The maximum rate with the collar is 5.30% and the minimum is 3.80%.

Example 2

In March, a company expects to borrow $8 million for 3 months from June. The current rate is 4%. It buys June put options on 3-month futures. Contract size is $1,000,000. Strike price is 95.50. Premium is 0.30 (annual percentage points). In June the market rate is either 6% or 3%. Assume the futures price at expiry equals 100 minus the market rate. Find the effective annual rate in each case.

Show the solution

Number of contracts = 8,000,000 ÷ 1,000,000 × 3/3 = 8 puts.
Tick value = 1,000,000 × 0.0001 × 3/12 = $25.
Premium = 0.30 = 30 ticks. Cost per contract = 30 × $25 = $750. For 8 contracts it is $6,000.
Rate 6%: futures price at expiry is 94.00. This is below the strike of 95.50, so exercise. Gain = 1.50 = 150 ticks × $25 = $3,750 per contract. For 8 contracts the gain is $30,000.
Rate 6%: interest on the loan is 8,000,000 × 6% × 3/12 = $120,000. Net cost = 120,000 − 30,000 + 6,000 = $96,000. Effective rate = 96,000 ÷ 8,000,000 × 4 = 4.80%. Check: (100 − 95.50) + 0.30 = 4.80%.
Rate 3%: futures price at expiry is 97.00. This is above the strike, so let the options lapse. Interest = 8,000,000 × 3% × 3/12 = $60,000. Add the premium of $6,000. Net cost = $66,000.
Effective rate at 3% = 66,000 ÷ 8,000,000 × 4 = 3.30%, which is 3% + 0.30%.

Answer: Buy 8 put options. If the rate is 6%, exercise and the effective rate is 4.80% (net cost $96,000). If the rate is 3%, let the options lapse and the effective rate is 3.30% (net cost $66,000).

Exam tips

Show the scenario table: market rate, exercise or not, interest, option gain, premium, effective rate. This is where the marks are and it makes errors easy to follow.
State your assumptions clearly: futures price equals 100 minus the spot rate at expiry (no basis), premium not financed, and rounding of contracts.
Check how the premium is quoted before you calculate. Exchange-traded premiums are usually in annual points; OTC premiums are often a flat percentage of the principal.
Do not stop at calculations. Compare options with FRAs, futures and swaps, and note the flexibility, the premium cost, and any mismatch on dates or amounts for exchange-traded contracts.
For professional skills marks, give a clear recommendation to the board or treasurer, tied to the company's view on rates and its tolerance for a loss of upside.

Practice questions from The use of financial derivatives to hedge against interest rate risk

Interest Rate Options and 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 Collars: frequently asked questions

What is the difference between an interest rate cap, floor and collar?

A cap sets a maximum rate on floating-rate borrowing. A floor sets a minimum rate, and a lender or depositor buys it. A collar combines the two: a borrower buys a cap and sells a floor, so the floor premium offsets part of the cap premium.

Why does a borrower buy put options on interest rate futures?

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

How do I calculate the effective rate with an interest rate option?

If the option is exercised, the rate is the strike rate plus the annualised premium. If it lapses, the rate is the market rate plus the annualised premium. Do this for each rate scenario the question gives.

What is an interest rate guarantee in AFM?

An interest rate guarantee is an OTC option on interest rates for a single future loan period, usually bought from a bank. It sets a maximum borrowing rate for that period. You pay a premium up front and can walk away if market rates are lower.

Why would a company choose a collar instead of a cap?

A collar costs less because the sold floor earns premium. The company accepts that it will not benefit if rates fall below the floor. It suits a company that wants protection but is unwilling to pay the full cap premium.