Interest rate caps as well as collars are available on the over the counter (OTC) market or may be devised using market based interest rate options. They may be utilize to hedge current or expected interest receipts or payments. An interest cap places an upper edge on the interest rate to be paid and is useful to a potential borrower of funds at a future date. The borrower by purchasing a cap will restrict the interest paid to the agreed cap strike price (less any premium paid). OTC caps are obtainable for periods of up to 10 years and can thus protect against long-term interest rate movements. As with all alternatives if interest rates were to move in a favourable direction the buyer of the cap could let the option lapse and take advantage of the more favourable rates in the spot market.
The major disadvantage of options is the premium cost. A collar option decreases the premium cost by limiting the possible benefits of favourable movements. It engages the simultaneous purchase and sale of options or in the case of OTC collars the equivalent net premium to this. The premium paid for the buying of the alternative would be partly or wholly offset by the premium received from the sale of options. Where it is completely offset a zero cost collar exists.