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. [1]
Accessible Version of Sample Interest Expense Chart:
Months | SOFR | Cap Strike | Floor Strike | Effective Interest Expense |
Year 1 | 3.00% | 3.75% | 3.25% | 3.25% |
Year 2 | 3.25% | 3.75% | 3.25% | 3.25% |
Year 3 | 3.50% | 3.75% | 3.25% | 3.50% |
Year 4 | 3.75% | 3.75% | 3.25% | 3.75% |
Year 5 | 4.00% | 3.75% | 3.25% | 3.75% |
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.[2].
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]
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.
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.
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