Final answer:
An interest rate collar is a combination of a cap and a floor, designed to protect against interest rate fluctuations outside a set range. The correct answer is option d.
Step-by-step explanation:
An interest rate collar is a financial derivative product that combines the features of an interest rate cap and an interest rate floor. Essentially, a collar provides a range within which the interest rate can fluctuate, providing the beneficiary with protection against interest rate movements beyond that range. If market interest rates stay within a normal range, the interest rate limits set by a collar are not binding. Nonetheless, should the equilibrium interest rate rise above or fall below the predetermined ceiling or floor of the collar, it will cap or floor the interest rate accordingly, preventing it from moving outside the set range.
The use of collars is a common hedging strategy for managing risks associated with interest rate fluctuations. A cap is an agreement to receive payments when the interest rate rises above a certain level, while a floor is an agreement to receive payments when the interest rate falls below a certain level. Combining these two derivatives forms a collar, which is used to limit exposure to changes in interest rates without completely eliminating the potential for benefiting from favorable rate movements.
In the context provided, usury laws set an upper limit on interest rates that lenders can charge, but these may be nonbinding if they are set above the market rate. Collars, caps, and floors are more precise tools for managing interest rates within specific ranges that may have direct and immediate financial implications on loan agreements, unlike a broader nonbinding price ceiling.
The correct answer to the question is D. Collar.