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In finance, a collar is an option strategy that limits the range of possible positive or negative returns on an underlying to a specific range. A collar strategy is used as one of the ways to hedge against possible losses and it represents long put options financed with short call options. [1]
A collar is created by: [2]
These latter two are a short risk reversal position. So:
The premium income from selling the call reduces the cost of purchasing the put. The amount saved depends on the strike price of the two options.
Most commonly, the two strikes are roughly equal distances from the current price. For example, an investor would insure against loss more than 20% in return for giving up gain more than 20%. In this case the cost of the two options should be roughly equal. In case the premiums are exactly equal, this may be called a zero-cost collar; the return is the same as if no collar was applied, provided that the ending price is between the two strikes.
On expiry the value (but not the profit) of the collar will be:
Consider an investor who owns 100 shares of a stock with a current share price of $5. An investor could construct a collar by buying one put with a strike price of $3 and selling one call with a strike price of $7. The collar would ensure that the gain on the portfolio will be no higher than $2 and the loss will be no worse than $2 (before deducting the net cost of the put option; i.e., the cost of the put option less what is received for selling the call option).
There are three possible scenarios when the options expire:
One source of risk is counterparty risk. If the stock price expires below the $3 floor then the counterparty may default on the put contract, thus creating the potential for losses up to the full value of the stock (plus fees).
In an interest rate collar, the investor seeks to limit exposure to changing interest rates and at the same time lower its net premium obligations. Hence, the investor goes long on the cap (floor) that will save it money for a strike of X +(-) S1 but at the same time shorts a floor (cap) for a strike of X +(-) S2 so that the premium of one at least partially offsets the premium of the other. Here S1 is the maximum tolerable unfavorable change in payable interest rate and S2 is the maximum benefit of a favorable move in interest rates. [3]
Consider an investor who has an obligation to pay floating 6 month LIBOR annually on a notional N and which (when invested) earns 6%. A rise in LIBOR above 6% will hurt said investor, while a drop will benefit him. Thus, it is desirable for him to purchase an interest rate cap which will pay him back in the case that the LIBOR rises above his level of comfort. Figuring that he is comfortable paying up to 7%, he buys an interest rate cap contract from a counterparty, where the counterparty will pay him the difference between the 6 month LIBOR and 7% when the LIBOR exceeds 7% for a premium of 0.08N. To offset this premium, he also sells an interest rate floor contract to a counterparty, where he will have to pay the difference between the 6 month LIBOR and 5% when the LIBOR falls below 5%. For this he receives a 0.075N premium, thus offsetting what he paid for the cap contract. [4]
Now, he can face 3 scenarios:
In times of high volatility, or in bear markets, it can be useful to limit the downside risk to a portfolio. One obvious way to do this is to sell the stock. In the above example, if an investor just sold the stock, the investor would get $5. This may be fine, but it poses additional questions. Does the investor have an acceptable investment available to put the money from the sale into? What are the transaction costs associated with liquidating the portfolio? Would the investor rather just hold on to the stock? What are the tax consequences?
If it makes more sense to hold on to the stock (or other underlying asset), the investor can limit that downside risk that lies below the strike price on the put in exchange for giving up the upside above the strike price on the call. Another advantage is that the cost of setting up a collar is (usually) free or nearly free. The price received for selling the call is used to buy the put—one pays for the other.
Finally, using a collar strategy takes the return from the probable to the definite. That is, when an investor owns a stock (or another underlying asset) and has an expected return, that expected return is only the mean of the distribution of possible returns, weighted by their probability. The investor may get a higher or lower return. When an investor who owns a stock (or other underlying asset) uses a collar strategy, the investor knows that the return can be no higher than the return defined by strike price on the call, and no lower than the return that results from the strike price of the put.
A symmetric collar is one where the initial value of each leg is equal. The product has therefore no cost to enter.
A structured collar describes an interest rate derivative product consisting of a straightforward cap, and an enhanced floor. The enhancement consists of additions which increase the cost of the floor should it be breached, or other adjustments designed to increase its cost. It can be contrasted with a symmetric collar, where the value of the cap and floor are equal. It attracted criticism as part of the Financial Conduct Authorities' review of mis-sold bank interest rate products. [5]
In economics and finance, arbitrage is the practice of taking advantage of a difference in prices in two or more markets; striking a combination of matching deals to capitalise on the difference, the profit being the difference between the market prices at which the unit is traded. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit after transaction costs. For example, an arbitrage opportunity is present when there is the possibility to instantaneously buy something for a low price and sell it for a higher price.
In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the "underlying". Derivatives can be used for a number of purposes, including insuring against price movements (hedging), increasing exposure to price movements for speculation, or getting access to otherwise hard-to-trade assets or markets. Some of the more common derivatives include forwards, futures, options, swaps, and variations of these such as synthetic collateralized debt obligations and credit default swaps. Most derivatives are traded over-the-counter (off-exchange) or on an exchange such as the Chicago Mercantile Exchange, while most insurance contracts have developed into a separate industry. In the United States, after the financial crisis of 2007–2009, there has been increased pressure to move derivatives to trade on exchanges.
In finance, a put or put option is a financial market derivative instrument that gives the holder the right to sell an asset, at a specified price, by a specified date to the writer of the put. The purchase of a put option is interpreted as a negative sentiment about the future value of the underlying stock. The term "put" comes from the fact that the owner has the right to "put up for sale" the stock or index.
In finance, a straddle strategy involves two transactions in options on the same underlying, with opposite positions. One holds long risk, the other short. As a result, it involves the purchase or sale of particular option derivatives that allow the holder to profit based on how much the price of the underlying security moves, regardless of the direction of price movement.
An interest rate cap is a type of interest rate derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price. An example of a cap would be an agreement to receive a payment for each month the LIBOR rate exceeds 2.5%.
In finance, the style or family of an option is the class into which the option falls, usually defined by the dates on which the option may be exercised. The vast majority of options are either European or American (style) options. These options—as well as others where the payoff is calculated similarly—are referred to as "vanilla options". Options where the payoff is calculated differently are categorized as "exotic options". Exotic options can pose challenging problems in valuation and hedging.
In finance, a futures contract is a standardized legal contract to buy or sell something at a predetermined price for delivery at a specified time in the future, between parties not yet known to each other. The asset transacted is usually a commodity or financial instrument. The predetermined price of the contract is known as the forward price. The specified time in the future when delivery and payment occur is known as the delivery date. Because it derives its value from the value of the underlying asset, a futures contract is a derivative.
In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed on at the time of conclusion of the contract, making it a type of derivative instrument. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into.
In finance, a convertible bond or convertible note or convertible debt is a type of bond that the holder can convert into a specified number of shares of common stock in the issuing company or cash of equal value. It is a hybrid security with debt- and equity-like features. It originated in the mid-19th century, and was used by early speculators such as Jacob Little and Daniel Drew to counter market cornering.
In finance, a swap is an agreement between two counterparties to exchange financial instruments or cashflows or payments for a certain time. The instruments can be almost anything but most swaps involve cash based on a notional principal amount.
Rational pricing is the assumption in financial economics that asset prices - and hence asset pricing models - will reflect the arbitrage-free price of the asset as any deviation from this price will be "arbitraged away". This assumption is useful in pricing fixed income securities, particularly bonds, and is fundamental to the pricing of derivative instruments.
Floating rate notes (FRNs) are bonds that have a variable coupon, equal to a money market reference rate, like LIBOR or federal funds rate, plus a quoted spread. The spread is a rate that remains constant. Almost all FRNs have quarterly coupons, i.e. they pay out interest every three months. At the beginning of each coupon period, the coupon is calculated by taking the fixing of the reference rate for that day and adding the spread. A typical coupon would look like 3 months USD LIBOR +0.20%.
In finance, a foreign exchange option is a derivative financial instrument that gives the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. See Foreign exchange derivative.
In finance, margin is the collateral that a holder of a financial instrument has to deposit with a counterparty to cover some or all of the credit risk the holder poses for the counterparty. This risk can arise if the holder has done any of the following:
In finance, a price (premium) is paid or received for purchasing or selling options. This article discusses the calculation of this premium in general. For further detail, see: Mathematical finance § Derivatives pricing: the Q world for discussion of the mathematics; Financial engineering for the implementation; as well as Financial modeling § Quantitative finance generally.
In options trading, a box spread is a combination of positions that has a certain payoff, considered to be simply "delta neutral interest rate position". For example, a bull spread constructed from calls combined with a bear spread constructed from puts has a constant payoff of the difference in exercise prices assuming that the underlying stock does not go ex-dividend before the expiration of the options. If the underlying asset has a dividend of X, then the settled value of the box will be 10 + x. Under the no-arbitrage assumption, the net premium paid out to acquire this position should be equal to the present value of the payoff.
Option strategies are the simultaneous, and often mixed, buying or selling of one or more options that differ in one or more of the options' variables. Call options, simply known as Calls, give the buyer a right to buy a particular stock at that option's strike price. Opposite to that are Put options, simply known as Puts, which give the buyer the right to sell a particular stock at the option's strike price. This is often done to gain exposure to a specific type of opportunity or risk while eliminating other risks as part of a trading strategy. A very straightforward strategy might simply be the buying or selling of a single option; however, option strategies often refer to a combination of simultaneous buying and or selling of options.
Options spreads are the basic building blocks of many options trading strategies. A spread position is entered by buying and selling options of the same class on the same underlying security but with different strike prices or expiration dates. An option spread shouldn't be confused with a spread option. The three main classes of spreads are the horizontal spread, the vertical spread and the diagonal spread. They are grouped by the relationships between the strike price and expiration dates of the options involved -
In finance, an option is a contract which conveys to its owner, the holder, the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price on or before a specified date, depending on the style of the option. Options are typically acquired by purchase, as a form of compensation, or as part of a complex financial transaction. Thus, they are also a form of asset and have a valuation that may depend on a complex relationship between underlying asset value, time until expiration, market volatility, and other factors. Options may be traded between private parties in over-the-counter (OTC) transactions, or they may be exchange-traded in live, orderly markets in the form of standardized contracts.
In finance, a credit spread, or net credit spread is an options strategy that involves a purchase of one option and a sale of another option in the same class and expiration but different strike prices. It is designed to make a profit when the spreads between the two options narrows.
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