What is the main characteristic of an interest rate collar?

An interest rate collar is primarily characterized by the simultaneous purchasing of an interest rate cap and the selling of an interest rate floor. This strategy creates a protective range on interest rate movements by combining two options.

The interest rate cap allows the holder to benefit when interest rates rise above a certain level, while the interest rate floor provides income when rates fall below a specified threshold. By using both strategies together, the investor can effectively hedge against rising rates while also capping the potential benefit from declines in rates. This creates a band or "collar" around the interest payments, protecting against extreme fluctuations.

Understanding this structure is essential because it highlights the risk management strategy employed in the debt and money markets by market participants looking to stabilize their cash flows in a variable interest rate environment.