Swap necklace

The debtor contracts the first financial option to establish a maximum interest rate, in exchange for the payment of a premium to the creditor. At the same time, a second option is negotiated to agree on a minimum interest rate. In return, it is the borrower who receives a premium.

This two-tranche operation guarantees that the debtor will not pay above an interest rate level. However, the lender is also assured of a minimum consideration for the financing granted.

The collar swap is typical of loans with a variable interest rate, where an interest rate is applied that depends on a reference index, for example, Euribor or Libor. To this is added a premium or differential.

Swap necklace elements

The elements of the swap collar are:

• Cap : It is a financial options contract by which the debtor pays a premium to the creditor to establish a maximum interest rate. That is, a call option is bought on interest rates, in which if the interest rate rises, the owner of the option receives a payment. Each option is known as a caplet.
• Floor: The debtor sells a financial option for which he receives a premium from the lender to ensure the payment of a minimum interest rate. That is, a sale option (put) is sold on interest rates, in which if the interest rate falls, the owner of the option receives a payment (and the seller has to pay). In this case, the seller is the one who makes the swap necklace. The payment you make on the option is from the point where you want to limit the interest below (the ground). Each option is known as a floorlet.
• Theoretical nominal: Principal of the loan to be covered. It is the amount on which the interest payable is calculated
• Reference interest rate: It is the index from which the credit interest rate is calculated.

When the Cap and Floor premium are equal we are faced with a zero premium necklace. In that situation, the debtor is not paying anything upfront for the coverage.

It should also be noted that an investor can use this type of strategy by buying a Floor and selling a Cap. In this way, it would be able to protect itself from an eventual drop in market interest rates.

Advantages and disadvantages of the swap collar

Among the advantages of the swap collar are:

• It allows setting a ceiling on interest expense in a financing operation.
• The creditor ensures a minimum income from interest generated on the loan granted.
• It is a flexible product that can be adapted to the needs of the client, mainly with regard to the range of interest rates that they are willing to pay.

However, there are also some disadvantages of the swap collar:

• The debtor will not be able to benefit from a sharp drop in interest rates.
• From the creditor’s point of view, the creditor will not be able to win because of a significant increase in the cost of the loan.

Swap necklace example

To better understand how the collar swap works, let’s look at a practical example with the following data for a financing payable in four quarterly installments.

• Maximum interest rate: 3% per annum
• Minimum interest rate: 2% per annum
• Nominal amount: 200,000 euros
• Reference interest rate: Libor at 90 days + 300 basis points
• Cap premium: 500 euros
• Floor premium: 300 euros

The cost of the coverage that is paid in period zero is 200 euros. This results from the difference between the premium paid for the purchase of the Cap and that received for the sale of the Floor.

Next, let’s assume that the initial 90-day Libor rate (in annual terms) is 2.5%, and that it then stands at:

• 90 days -> 3.1%
• 180 days -> 2.7%
• 270 days -> 1.9%

So, at each expiration the following would happen:

90 days:

Interest payment: 200,000 * (0.025 + 0.03) * (90/360) = 2,750 euros

The interest rate is within the expected range and the swap collar is not activated.

180 days:

Interest payment: 200,000 * (0.031 + 0.03) * (90/360) = 3,050 euros

The benchmark index (3.1%) has exceeded the maximum covered by the Cap (3%), for which the debtor receives the following compensation: 200,000 * (0.031-0.03) * (90/360) = 50 euros

Therefore, the borrower’s net outlay is: 3,050-50 = 3,000 euros.

270 days:

Interest payment: 200,000 * (0.027 + 0.03) * (90/360) = 2,850 euros

The interest rate is within the expected range and the swap collar is not activated.

360 days:

Interest payment: 200.00 * (0.019 + 0.03) * (90/360) = 2,450 euros

The benchmark index (1.9%) is below the minimum covered by the Floor, so the debtor must make the following additional disbursement: 200,000 * (0.02-0.019) * (90/360) = 50

Thus, the total payment of the borrower would be: 2,450 + 50 = 2,500 euros.