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In financea 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.

A collar is created by: These latter two are a short risk reversal position. 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. 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.

There are three possible scenarios when the options expire:. One source of risk is counterparty risk. 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. 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.

Thus it is desirable for her to purchase an interest rate cap which will pay her back if the LIBOR rises above her level of comfort. For this she receives 0. In times of high volatilityor in bear marketsit can be useful to limit the downside risk to a portfolio. One obvious way to do this is to sell the stock. 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 assetthe 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 returnthat 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 capand 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. From Wikipedia, the free encyclopedia. This article has multiple issues. Please help improve it or discuss these issues on the talk page.

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