Series 50: Caps And Collars

Caps and Collars

An issuer may use an interest rate cap to hedge against interest rate risk on variable-rate bonds. In an interest rate cap, the issuer pays a premium (or series of premiums) to a counterparty, and if interest rates go above a certain strike rate, which is called the cap, the counterparty must pay the issuer the difference between the market rate and the strike rate times the value of a notional amount.

Example: Goodville issues $10,000,000 of variable-rate demand obligations. Interest rates are currently at 4%, but Goodvi