PRMIA Exam 8006 Topic 5 Question 51 Discussion

Interest rate caps are effectively call options on an underlying interest rate that protect the buyer of the cap against a rise in interest rates over the agreed exercise rate. As with options, the premium on the cap depends upon the volatility of the underlying rates as one of its variables. A floor is the exact opposite of a cap, ie it is effectively a put option on an underlying interest rate that protects the buyer of the floor against a fall in interest rates below the agreed exercise rate.

A cap protects a borrower against a rise in interest rates beyond a point, and a floor protects a lender against a fall in interest rates below a point.

A collar is a combination of a long cap and a short floor, the idea being that the premium due on the cap is offset partly by the premium earned on the short floor position. Therefore a collar is less expensive than a cap or a floor.