Fresh Green plc (Fresh Green) operates a chain of vegetarian restaurants in Northern Ireland.

After a period of rapid growth it is now looking at expanding its operations.

A large multinational company has decided to sell off a small chain of restaurants in Wales and Fresh Green has agreed to buy the chain for 15 million.

The purchase price must be paid immediately and Fresh Green has decided to finance the acquisition by borrowing 15 million at a floating rate of LIBOR + 0.80% with interest being payable at the end of the year.

Fresh Green is concerned that interest rates may fluctuate over the next year and is considering what action, if any, should be taken to hedge the interest rate.

The company has been offered a cap at LIBOR 7% for a premium of 1.1% per year and a bank has offered to buy a floor from the company at LIBOR 5.1% for a premium of 0.8% per year. The company is currently considering three options, which are:

(1) To purchase a cap

(2) To purchase a collar

(3) To do nothing

Requirement

(a) Briefly describe the main features of a cap, a floor, and a collar and outline the advantages and disadvantages of each.

(b) Calculate the effective interest rates from each option and comment briefly on the results, assuming that the LIBOR rate for next year is:

(i) 4.7%

(ii) 5.8%

(iii) 7.3%

(c) Identify and discuss an alternative method of hedging against interest rate movements that Fresh Green may consider.