Suppose you are a manager of a financial institution. You recently purchased a three-year interest rate collar with LIBOR as the interest rate index. The interest rate cap specifies a fee of 2% of $60 million notional principal and an interest rate ceiling of 9%. The interest rate floor specifies a fee of 3% of the $60 million notional principal and an interest rate floor of 7%. Assume that LIBOR is expected to be 6%, 10%, and 12% (respectively) at the end of each of the next three years.

1.If you are certain that interest rates will rise, should you consider purchasing a callable swap instead of the collar? Explain.

• 2. Explain the conditions under which your purchase of an interest rate collar could have unintended consequences.