A Collar Option is a type of Structured Option which allows you to protect against the risk that the Spot Rate will be less favorable than a nominated Protection Rate. It also gives you the ability to participate in favorable movements in the spot market between your nominated rate and a Best-Case Rate. Collar Option Contracts are often used by importers and exporters.
Key Risks of Using a Collar Option Include:
- The Protection Rate is generally less favourable than the comparable Forward Rate;
- Your participation is capped at the Participation Rate. This means that if the Spot Rate is more favorable than the Participation Rate, you will be obligated to deal at the Participation Rate.
Key Benefits of Using a Collar Option Include:
- You are able to participate in favourable rate movements up to the Participating Rate;
- Collar sets the Protection Rate as the Worse-Case Rate to protect you from any adverse market movement.
Key Features Summarized
- Risk Profile: Low
- Downside Risk Protection: Yes
- Upside Participation: Yes
- Enhanced Rate on Strike: No
- Allowing Predelivery: Yes
Trading Example
As an exporter of Australian-made products, you are invoicing your overseas customers to receive USD 500,000 via a stream of payments in the upcoming 6 months. The current AUD/USD Spot Rate is at 0.7150. You would like to have your cost rate of 0.7350 protected; however, as you are unsure where the AUD/USD will travel in the coming half-year given the volatilities, you would also like to benefit from favourable market movements below 0.7000.
Therefore, you consider the following Collar Option:
- Protection Amount: Selling USD 500,000 into AUD
- Protection Rate (Cap Rate): 0.7350
- Participation Rate (Floor Rate): 0.6950
- Expiration Date: 6 months.
Structure Details:
- Buying an AUD Call /USD Put, strike at 0.7350, Notional USD $500,000, expiring in 6 months.
- Selling an AUD put /USD Call, strike at 0.6950, Notional USD $500,000, expiring in 6 months.
Outcome at Expiration Date (6 months):
- Outcome 1: On the Expiration Date, if the Spot Rate finishes at 0.7800, you can choose to use the protection to sell USD 500,000 at the Protection Rate (Cap Rate) of 0.7350. This provides 100% protection to the client at the Cap rate.
- Outcome 2: On the Expiration Date, if the Spot rate drops below your Participation Rate of 0.6950, say at 0.6700, you can sell your USD 500,000 at the Participation Rate of 0.6950. Therefore, you have participated in the favourable AUD/USD movement down to the Participation Rate of 0.6950, which means a better result than dealing in a standard Forward.
- Outcome 3: If the Spot Rate finishes between 0.6950 and 0.7350, say at 0.7200, the Option will lapse, i.e., there is no obligation for you, and you might choose to deal at the market spot rate.
Payoff Diagram
