In high interest rate environments, zero-cost collars are a common tool used to hedge loans. A zero-cost interest rate collar is created by combining an interest rate cap and an interest rate floor of equivalent value.
Following the onset of the pandemic in 2020, the Federal Reserve reduced its Federal Funds Rate Target Range to 0 - 0.25%. Short-term variable rates such as LIBOR and SOFR were anchored near zero for the following two years as the Fed shifted towards a more accommodative monetary policy. This eliminated zero-cost collars as a viable hedging tool, because floors in that environment held almost no value. Borrowers generally either let their interest rates float or turned to caps or swaps for hedging.
Since March 2022, the Fed has raised interest rates at a pace not seen since the 1980s, bringing the Fed Funds Rate Target Range to 4.50% - 4.75%. Given the subsequent increase in SOFR, zero-cost interest rate collars have once again become attractive hedging tools, as SOFR floors now have much greater 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:
*The above scenarios do not account for rates being negative; the borrower would bear risk should the loan index rate decline below zero.
A sample payout structure for a five year zero-cost interest rate collar with a cap strike of 3.75% and a floor strike of 3.25% is shown below. 
Accessible Version of Sample Interest Expense Chart:
|Months||SOFR||Cap Strike||Floor Strike||Effective Interest Expense|
Zero-cost collars can be structured to hedge a projected draw schedule, a constant amount, or to align with projected amortization of a loan.
The advantage of using a zero-cost interest rate collar include:
Some of the risks of a zero-cost interest rate collar include:
Current indicative zero-cost collar pricing using various cap strikes and tenors is shown in the tables below..
Please reach out to your derivatives marketer or relationship manager if you would like to discuss zero-cost interest rate collars in further detail.
1. Please note that the cap and floor strikes are not indicative of current pricing and are hypothetical for informational purposes.
2. As of 2/3/2023. Rates based on spot-starting, non-amortizing, Daily Simple SOFR, Act/360 structures.
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