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:

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]