Cap, Floor and Collar

If you are worried about interest rate fluctuations (eg. you want to buy a bond or take on a credit) you might use one of the following instruments:

Cap

If you are worried about rising interest rates (eg. you want to buy a bond) then a Cap might be the right thing for you. How does it work: If the reference interest rate (eg. EURIBOR) reaches a predefined upper limit then you receive the difference between your agreed interest rate (the upper limit you set) and your reference interest rate.

Floor

If you are worried about falling interest rates then a floor might be the right thing for you. How does it work: If the reference interest rate (eg. EURIBOR) reaches a predefined lower limit then you receive the difference between your agreed interest rate (the lower limit you set) and your reference interest rate.

Collar

With a collar, you can protect yourself in both directions. If the reference interest rate (eg. EURIBOR) reaches a predefined upper limit then you receive the difference between your agreed interest rate (the upper limit you set) and your reference interest rate. If the reference interest rate (eg. EURIBOR) reaches a predefined lower limit then you pay the difference between the agreed interest rate (the lower limit you set) and your reference interest rate. So you act as a buyer of the cap and as a seller of the floor. That means you receive a premium cause you act as a seller of the floor. This premium protects you to some extent from interest fluctuations. However one must also account for the premium that one needs to pay for the call.