A floating-rate lender wants to use a collar as a hedge. Which of the following is appropriate?
A) Buy a cap and sell a floor
B) Buy a cap and buy a floor
C) Sell a cap and sell a floor
D) Sell a cap and buy a floor

Question

Quizplus · Accepted Answer

A collar involves buying a cap to limit the maximum interest rate payable and selling a floor to offset the cost of the cap. Therefore, the lender needs to sell a cap and buy a floor to set the minimum interest rate payable. This will provide a range within which the interest rate payable is fixed. Buying a cap and selling a floor would not provide an effective hedge as it would eliminate the benefits of the cap by selling the floor. Therefore, option D is the appropriate choice.

A Floating-Rate Lender Wants to Use a Collar as a Hedge