This content introduces and explains the "collar" strategy in options trading, specifically for interest rate futures (IRF). A collar is a combination of options designed to reduce the premium cost of hedging, but it limits potential upside gains.
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So I'm going to go through something
very interesting right now which is a
new strategy but not totally new but
it's just a blend of what we've looked
at before and is options. Color is a
form of options but a combination of
options. So I call it option combo that
is just from me to for you to remember.
is a combo of options and I'm going to
show you how this works. Remember a
typical option in IRF. So we're looking
at color for interest rate futures.
Remember we've looked at options. In
fact, we've looked at interest rate
futures. We've looked at options on
interest rate futures. Now this is a
caller on interest rate futures.
And I'll explain but please follow me
slowly. Let me quickly take your mind
back to the last video where we spoke
about options on IRF. When we said for a borrower,
borrower,
this borrower is worried about something
interest rate.
That's his problem.
That is worried. So which means this guy
is saying that I don't want to pay more
than a certain amount of interest rate.
So because of that he put a cap. And how
will he put that cap? Usually he will
put a cap by
buying an option. And what type of
option do we agree? Because it's a
borrowing which means he wants to sell a
bond. So he will buy an option that is
called put. So he's going to buy put on
interest rate future.
So with this he has put a limit to
interest rate. So if interest rate goes
beyond this level
he's not worried. He's fine. And as it
is by the time interest rates start
coming down this guy has access to
to
this unlimited benefit.
So take for instance if he has fixed his
rate as say maybe the strike price is
10% here. If this goes to 7 8 5 3 2 can
throw away the option and just go to the
market and enjoy the full benefit
benefit of what the market is doing. He
has access to this and please take note.
Yes, access to unlimited benefit and you
can discard the option. But if the op if
the interest rate decides to go upward
as well, he can just limit his exposure
to that strike price and exercise. So
you know that here this guy will exercise.
exercise.
Yeah. To take care to use this particular
particular
rate. However,
at this place, you will not exercise.
And why will you not exercise? Because
you want to take the full benefit of the
spot rate, which is the market. Because
the market is favorable.
The same thing for deposit that is
worried about decreasing rate. What the
guy would do? So, let me just quickly do
that. For a deposit,
the guy is worried about decreasing
rate. So if he's worried about
decreasing rate, usually what he does is
he's going to buy an option as well. But
this time he's going to buy a floor
which is a call option and options to
sell because an investor to buy rather
is an option to buy because an investor
want to buy a bond. Yeah. So and what
does that mean? If he buys a bond, he
wants as much interest as possible. So
his fear is that he doesn't want
interest rate that is low. So because of
that he will buy a flaw. So this is a flaw
flaw
which means his own protection is
interest rate not coming down. So if
interest rate decides to come down he
will exercise because he has already
Yeah. Which means anything that goes up
here, the guy will be excited because if
the market is here more than his strike
price, it will exercise
cuz no it will not excine. So this will
not exercise because it will just take
care of the market. It will just go for
the market straight away. This is where
it will exercise. Yeah, it will not
exercise because this is the worst case.
Anything higher is good for him. So here
to that unlimited benefit
while also
fixing his loss.
That's his maximum loss that he has
fixed there.
Now this looks fantastic but there's a
disadvantage and that's why caller came
and the disadvantage is the fact that
you are always buying whether a call or
a put you are always buying and when you
So the disadvantage is that this might
and that's what gave rise to that
strategy to reduce premium. So to reduce
that premium
the color came up.
Want to reduce your premium then you
have to use a color strategy.
for color strategy. What this is saying
is that instead of you to always buy,
why don't you do two things? Yeah. Which
means yes, you buy your normal option
which means for borrowing buy your put
for deposit buy your car.
Yeah. So buy your normal option. Yeah.
And you buy your normal option. Yes. You
will pay your premium as normal.
But in addition, why don't you establish
a side contract on the opposite that you
are selling? So sell the opposite.
So you sell opposite
option. So which means for a borrower
that has sold I mean that has bought a
put as a normal option. Yeah, borrower
you have bought a put.
You come here on the opposite and do
what? sell a call at a different strike
price, definitely lower strike price.
You will see. I'm going to work an
example to show you in practical sense
how it works. Yeah. But remember, once
you sell an option, what do you get? You
Receive a premium. So which means if you
pay a premium and you receive a premium
then definitely you have reduced net premium
and that is color strategy. It has it
own disadvantage and as you will see in
the example I'm going to show you now
the problem is that when you use a
collar you will lose this maximum
access. You going to have a limited
access. You can have unlimited benefits
on the upside and that is disadvantage.
You are restricted.
You see how restricted to certain upside
and what what do I mean by that? Let's
let's use borrower for an example which
is a popular one even in question they
tend to ask for borrower more than
deposit but they can ask for deposit as
well. So normally what are we going to
do if you have a borrower? Borrower is
someone that want to borrow money
someone that wants to borrow money is
someone that wants to sell a bond. So if
you want to get interest rate futures it
will be interest rate futures to sell a
bond. So if you want option on that
that's an option to sell IRF and what is
So let's say for instance that is at uh
let's say at 7%.
So which means that is the cap for the
guy 7%. So this is the maximum interest
he will pay. the maximum interest expense
expense
will be because anything above that you
will exercise this option and it will
pay 7%. Right?
So with this one [clears throat]
this is a this is a put option that you
So you are long
on put option. What that means is that
uh you've bought remember terminologies.
So it means by you bought a put option
So you must have paid premium.
But at the same time to reduce this
premium then you need to come down
and set another level and say okay this
such that you're doing such that the
likelihood of the person exercising is
very slim because you know that
your upside normally without this 5%.
If you don't have this 5%
it means that the whole of this place
once the rate keeps coming down is just
for your benefit because you will just
ignore this 7%. And go with the market
by the time you decide to draw this line
and say you want to sell an option at
5%. Remember you have to sell an
opposite option which means you're going
to sell a call.
And I'm sure you know what that means.
Once you sell a call, yeah, say to party
B, you know what that means? It means that
that
you gave So if this is A, let's say this
is party A. Yeah. It means that A has
given a right to B, right?
right?
A has given a right to B, a right to
party B
to buy.
Remember is a call. So part B now has a
right to buy IRF.
Yeah. At what rate?
At 5%. So which means part B will
receive interest income inflow
at 5%.
So part party B is using this 5%
as its own worst case scenario. So which
means once the interest rate is above 5%
party B will not worry you and that is
why this portion
is your own limited
upside that you can have. So your upside
is limited to this spot as party A. So
this limited upside for party A.
Normally it would have been the whole of
this downward trend but because of this
transaction that's not the case because
anytime the interest rate is around here
but B will exercise
anytime so take for inance if interest
rate is 3%.
A cannot say he wants to do market at 3%.
3%.
He can't dict that benefit. Even if he
does it, let's even say he does it, you
will see how he's going to nail out. So
if you say he want to exercise which at
3%, so if a exercise at 3%, then he has
a benefit of 4%. That's 7 - 3, right?
But remember
what happens to party B. Party B has
already said my worst case scenario for
my income is 5%. So if Marcus is doing
3% then he's going to exercise and he's
going to come for party A to pay him the
net loss because he's going to be
getting 3% then party A will have to
make it up for him at 2%. So which means
party A will lose 2%. To be and what is
the net for party A 2%. Which still goes
back to 7% less 5%. So your upside as a
caller seller
once you do the strategy caller just
know that your upside is limited.
I think the same thing opposite for
deposit. If you look at deposit is the
same thing similar.
Can try and do it yourself before you
look at the way I'm going to do it.
Yeah, it's just opposite because
normally what is the problem with the
deposit guy? Deposit guy wants his
interest to go up. So he's afraid of
coming down which means what he's going
to do is that this guy will want to fix
his flaw.
Yeah. So let's call it X not. So which
because
if rate goes below that
and you collect his X not. However,
However,
he's supposed to enjoy unlimited upside,
but because he wants to reduce his
premium, he will decide to sell
something there.
And what he's going to sell, remember
for a deposit, what you are buying normal,
normal,
yeah, this your normal
Yeah. So which means this time around
for a caller to complete going to sell a
put. And what is selling a put means?
Selling a put to party B means that you
have actually given
a right to party B
to sell a bond which means you will pay
interest. Part B will pay interest at a
fixed rate. So which means part A will
not pay interest more than this level.
So when interest goes beyond this point,
party A will have to compensate party B
for that. And that is why party A will
be limited to this upside.
And that is why color
can be
annoying in as much as it's trying to
minimize your premium because of the
inflow of premium you get by selling
those options. Likewise, if the market
turns to be very good, your flexibility
is not as flexible. That is the summary.
I'm going to quickly just do this
question to drive it even further home.
Good question here. Take one second,
look at it, and see where I'm going to
deal with it quickly. Yeah, here we have
two scenarios. If the base rate rises to
9.5% and future prices move to 90.2% uh 90.2
90.2
we should calculate the effective
interest rate for the company using
color. Remember they want to use color.
So and what is happen is they are trying
to borrow to borrow. So which means we
have normal
is going to be the normal
expectation. And what's the normal
expectation? So we're trying to set up
the color now. Yeah right. So to set up
the color, let me say this is color.
Yeah, the normal is to buy put.
Yeah, if you're setting up a color,
don't look for cheapest strike price
because your
strike price
in a collar for the put has to be higher
interest rate. Don't go for the don't go
for a lower one because that will make your
your
color to be defective. So you buy put
you have 92 and 93 there. So the
interest rate here is 92 which is 8%. So
buy put 92
and um that is 8% to make it clear and
you do the opposite and sell call at 93.
Yeah. And that is 7%. Yeah. But are we
using March or June? If you look at the
question the transaction will happen 1st
of January. So we need to use March. We
don't need to use June because March
option will expire end of March. So
we're good. We don't need to
think about June in that sense. So which
means in terms of our premium for this
color, our premium will be
we're paying 93 as uh 92 for for putm.
So pay 0.2%
0.2%
and we'll receive
So which means
in terms of net premium this is going
out and this is coming in. So our net
premium in that sense will be let me put
on calculator that's 2 minus.15
That's the premium situation.
Yeah. But are we going to exercise now
that we have this option there? Let's
look at it. What is the outcome of the
collar? If interest rate goes to 9.5%.
That is already higher than our strike
price of 8%. Yeah, remember what we have
is it this is our cap 8% and we did
color at 7%. So now interest rate has
gone to 9.5%.
So which means at this point we will exercise.
exercise.
Will this guy exercise? No, he will not
exercise because this is the worst case
scenario. If market has gone to 9.5, we
rather stick to a market and ignore. So
which means is a money for us but it's
out of money for the guy for his own
other side. So which means premium is
sealed. We have that we exercise at 9.5
market. So definitely we're going to do
our normal buying and selling of
features. And that means
92 was our future. So we initiated at 92
and we close at 90.2.
So which means we're borrowing at 8%,
we're paying at 8%.
Yeah. And we are actually receiving at
uh 9.8%.
And that will give you
profit of 1.8% 8% is same as 1.8 that
you have here. Yeah, this is one way of
doing this another way of doing it.
Yeah, but for interpretation I prefer to
do the second way so that you can be
clear to you. Remember this is boring.
Yeah, boring at 92 when you start when
you buy the future initially. Now this
is when you uh this is when you sell the
future. Sorry, you sell the interest
rate feature here and you buy back here
because the option you remember the
option is a put option option to sell
the bond. When you sell bond you pay
interest on it because you are raising
fund right so now we have net 1.8% 8%
there we have to keep it. So let's put
everything together. Base rate. So the
rate transaction is the third leg.
The rate transaction is 9.5 base. So
which means to get the total interest
rate for a question A. So we have the
rate transaction at base 9.5%.
The question told us that there's a
margin of plus 2%. Which is fixed.
That's the margin. Then from um
feature closing we made 1.8. So that
will help us is a gain. So that will
reduce our cost. Uh on premium
unfortunately is a
liability for us net liability. So we
need to pay 0.05%.
And when we put all of this together
let's see what it gives us. So we have
9.5 + 9.5 here + 2
+ 005 11.55 - 1.8
and that gives us 9.75%.
Easy. That's the effective interest
rate. Yeah. And this is what we apply to
the principal to get the net position.
That is A. Similar
process we're going to use for B. And
for B what is going to happen? Remember
what happened? This same diagram 8% 7%.
That is our own cap and we sold call at
7%. Unfortunately, market came and life
happened. And what happened? The
interest rate in reality decided to go
to something much lower, 4.5%.
At 4.5%
we will definitely forget about our own
option because we already said the
maximum we want to pay at 8%. We will
not exercise that kind of option and
start paying at 8% when market is doing
4.5%. So that is gone. We're not going
to our option is useless.
But our premium we paid it is a some
cost is still there. So which means
remember this net will still be
relevant. So we're still going to bring
it down. So premium
let me call it net premium is still
available at 0.05%
cost. Yeah.
And real reality of markets will also
happen. Reality is uh 4.5%
plus margin of 2% that is always fixed
So we know the net premium, we know the
reality. Now we need to know what is
happening to the RF interest rate
features. What is the next situation? So
in this case we already said for us our
IRF will expire but the IRF for this guy
will be exercised because the market is
doing below his strike price and because
of that he will take advantage of IRF
and for him to take advantage of the
IRF. Remember what happened was the fact
that he bought IRF at strike price of um 93.
93.
I think we sold at 93. Yes. So we did
call at 90. That's why it's 7%. Yeah. So 93
93 was
was
when he actually bought that call which is
is
decide to exercise. Then he bought at 93
and you would need to sold you need to
sell rather at what the market is doing
on the future which is now 96.1.
So you need to close that feature. 96.1.
Yeah, if you look at it this way, that
will give you a difference of 93 minus 96.1.
96.1.
That's 3.1%.
But the reason why I don't like explain
like this with these numbers is you
might be stuck to know whether it's a
gain or
or loss. But the way to know is the fact
that if he's exercising is a gain,
right? And if it's a gain for him, it's
a loss for us. That's one way to look at
it. One way to look at it is that when
he bought, he bought means that he's
going to receive interest inflow at 7%.
So that's you get inflow at 7%. And when
he's selling, he's going to be paying at 3.9%.
3.9%.
So he's left with positive 3.1%. That's
another way to look at it. Okay. So if
the guy is making positive, definitely
we are making negative. And that is why
for us it would be a negative 3.1. So
that is a I'm call plus to avoid
confusion but I'll just call it 3.1
because I've measured all the other cost
at positives. So if you add all the cost
together we have 05% which is our net
premium plus the market doing 4.5% base
then that will be a 2% margin for the
company risk and the IRF will close at
additional loss for us 3.1%.
So when we add all of these together
quickly, 005 + 4.5
+ 2 + 3.1
that gives us 9.65%.
So if market decides to go that route,
then our effective interest rate is 9.65%.
9.65%.
despite the use of our collar. So you
see that not too far away but it can
give a different result depending on our
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