Just as in other markets, it is common in the interest rate market to trade collars.
A collar is the combination of a cap and a flaw with a hedger buying one and selling the other.
The graph on screen shows a 4% versus one point a half percent cap floor collar.
The collar has been constructed to be net zero premium as is the norm, so that the hedger has nothing to pay upfront.
We can see that between the two strikes, their borrowing costs move up and down with your eyeball.
If your eyeball moves up above the cap strike, they are protected by their borrowing cost being kept at 5.5%.
Note, there's no extra basis points of premium with the collar as this is a net zero premium collar.
However, if your eye goes down below the floor strike, they minimum borrowing cost is now flawed at 3%, which is the floor strike plus their loan margin.
Zero premium collars are very popular with hedges because of the lack of premium.
The protection offered by the cap is still being paid for of course, but instead of the payment being in cash, it is now in the lost opportunity to benefit if your IBO goes down below 1.5%, many hedges will jump straight from swaps to zero premium collars in their hedging evolution, driven by a reluctance to pay the upfront premium cost of a standalone cap.
This is especially true of non-financial counterparties who do not have large cash reserves to spend on options.
