Hedging Interest Rate Risk Using Caps, Floors and Collars
Interest rate cap:
A cap involves using interest rate options to set a maximum interest rate for borrowers. If the actual interest rate is lower, the option is allowed to lapse.
Interest rate floors:
A floor involves using interest rate options to set a minimum interest rate for investors. If the actual interest rate is higher the investor will let the option lapse.
Interest rate collar:
A collar involves using interest rate options to confine the interest paid or earned within a pre-determined range. A borrower would buy a cap and sell a floor, thereby offsetting the cost of buying a cap against the premium received by selling a floor. A depositor would buy a floor and sell a cap.
Source: Ken Garrett , ACCA