Revisiting Interest Rate Collars as a Hedge
for Construction Loans
Prior to the financial crisis, zero-cost interest rate collars were a common tool used to hedge construction loans. A zero-cost interest rate collar is created by combining an interest rate cap and an interest rate floor of equivalent value.
However, during and following the financial crisis, the Fed reduced its Fed Funds rate to 0 – 0.25%, which caused LIBOR to fall to approximately 0%. This eliminated zero-cost collars as a viable hedging tool, as floors in this environment had almost no value. Borrowers generally either let the interest rate float or turned to caps or swaps for hedging.
Since December 2015, the Fed has raised its Fed Funds Target Range nine times to 2.25 – 2.50% and LIBOR has similarly risen. Given the increase in LIBOR, zero-cost interest rate collars have once again become an attractive tool for hedging interest rate risk as LIBOR floors once again have value.
For illustrative purposes, a borrower’s effective interest rate on a floating rate loan with a zero-cost interest rate collar is as follows:
- If LIBOR is below the floor strike, the borrower’s interest rate is the floor strike rate plus the loan spread.*
- If LIBOR is between the floor and cap strikes, the borrower pays LIBOR plus the loan spread. The LIBOR rate floats between the floor and cap levels.
- If LIBOR is above the cap strike, the borrower’s interest rate is capped at the cap strike rate plus the loan spread.
*However, if LIBOR drops below 0% and the loan has a 0% LIBOR floor, the borrower’s interest rate increases bp-for-bp to the extent that LIBOR is less than 0%.
A sample payout structure for a five year zero-cost interest rate collar with a cap strike of 2.75% and a floor strike of 2.25% is shown below.[1]
Accessible Version of Chart:
| Months | 1m Libor | Cap Strike | Floor Strike | Effective Interest Expense |
| Year 1 | 2.00% | 2.75% | 2.25% | 2.25% |
| Year 2 | 2.25% | 2.75% | 2.25% | 2.25% |
| Year 3 | 2.50% | 2.75% | 2.25% | 2.50% |
| Year 4 | 2.75% | 2.75% | 2.25% | 2.75% |
| Year 5 | 3.00% | 2.75% | 2.25% | 2.75% |
Zero-cost collars can be structured to hedge a projected draw schedule, and can be amended if actual draws differ from projected draws.
The advantages of using a zero-cost interest rate collar include:
- No increase in interest rate or cost (assuming the floor strike is below LIBOR)
- Protection against LIBOR rising above the cap strike
- Can benefit from LIBOR possibly falling (to the floor strike)
Some of the risks of a zero-cost interest rate collar include:
- LIBOR could fall below the floor strike rate, requiring the borrower to make payments.
- There could be a termination payment either owed or due (depending on interest rates) if terminated prior to maturity.
Current indicative zero-cost collar pricing using various cap strikes and tenors is shown in the tables below[2].
Contact Us
Please reach out to your derivatives marketer or relationship manager if you would like to discuss zero-cost interest rate collars in further detail.[3]
Important Legal Disclosures & Information
1. Please note that the cap and floor strikes are not indicative of current pricing and the LIBOR curve included is exclusively for informational purposes.
2. As of 4/22/2019. Rates based on spot-starting, non-amortizing, 1M LIBOR, Act/360 structures.
3. The information contained herein (“Information”) was produced by an employee of PNC Bank, National Association’s (“PNC Bank”) foreign exchange and derivative products group. Such Information is not a “research report” nor is it intended to constitute a “research report” (as defined by applicable regulations). The Information is of general market, economic, and political conditions or statistical summaries of financial data and is not an analysis of the price or market for any product or transaction. This document and the Information it contains is intended for informational purposes only, and should not be construed as legal, accounting, tax, trading or other professional advice. You should consult with your own independent advisors before taking any action based on the Information. Under no circumstances should the Information be considered trading advice or a recommendation or solicitation to buy or sell any products or services or a commitment to enter into any transaction. The Information is gathered from sources PNC Bank believes to be reliable and accurate at the time of publication and are subject to change without notice. PNC Bank makes no representations or warranties regarding the Information’s accuracy, timeliness, or completeness. All performance, returns, prices or rates are for illustrative purposes only. Markets do and will change. Actual results will vary, and may be adversely affected by exchange rates, interest rates, commodity prices or other factors.
PNC is a registered service mark of The PNC Financial Services Group, Inc. (“PNC”). Foreign exchange and derivative products are obligations of PNC Bank, Member FDIC and a wholly owned subsidiary of PNC. Foreign exchange and derivative products are not bank deposits and are not FDIC insured, nor are they insured or guaranteed by PNC Bank or any of its subsidiaries or affiliates.
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