An interest rate collar is a strategy employed by borrowers and lenders to manage the risk of rate movements in floating-rate debt. It is a hedging technique that combines selling a covered call with simultaneously buying a protective put to form a floor and cap on interest rates. A borrower will buy a collar with either a long put and short call, or a long call and short put.

Both borrowers and lenders may choose to employ interest rate collars to protect against unfavorable rate movements. In the case of a borrower, the collar cap limits potential interest rate increases and protects against payment shocks, while for lenders, the collar floor limits potential interest rate decreases and protects against lower returns on their holdings. A reverse collar is often used by lenders, which involves using a call as a cap and a put as a floor.

The collaring strategy follows the same premise as any option strategy in that it involves the buying and selling of options contracts. In the case of a borrower, a put option is purchased to set a rate floor, meaning that the interest rate cannot fall below this level. A call option is then sold to set a rate ceiling, meaning that the interest rate cannot rise above this level. The cost of buying the put and selling the call is offset by the premium received from selling the call to form a financial collar, ensuring that both the upside and downside of the interest rate are limited.

While your risk is effectively hedged by an interest rate collar, the trade-off is that any potential upside that would have been conferred by a favorable movement in rates will also be limited. Depending on the market outlook, collaring can be a useful tool to manage financial risk, but it is important to weigh the cost of paying the premium against the potential benefits of increased returns.