Risk management. A form of hedge using options.
Collar hedges are more complex structures, compared with a simpler cap option or floor option.
An advantage of collars is that they can reduce the net premium paid for the hedge. They do this by adding a short option position to the simple cap or floor. In other words by the corporate hedger selling an option (in addition to buying the simple cap or floor option).
The premium received by the corporate reduces their net premium payable. The net premium payable is often zero. (This arrangement is called a zero cost collar.)
It is also possible - though less common - to construct a negative cost collar, the net premium being receivable by the corporate.
The case where the corporate hedger pays a net premium for the collar is known as a positive cost collar.
In all cases, the net result and intention is to ‘collar’ the all-in hedged rate achieved within a range which is acceptable to the hedging corporate.
Collars are also known as cylinders, corridors or range forwards.