There are three forms of interest rate options, which are CAP, FLOOR and COLLAR. They refer to practices whereby a buyer of the option, upon paying an option premium, is entitled to exercise the right when the change in interest rate exceeds the range stipulated in the option contract, so as to control the interest rate risk.
Interest rate options are effective tools to avoid interest rate risks. The buyer of the option can get relatively flexible protection on the condition of paying a specific fee (option premium). If the market interest rates move in an adverse direction, the buyer can execute the option to lock in the interest rate risk. Alternatively, if the market interest rates move in a favorable direction, the buyer can choose not to execute the option in order to enjoy more favorable market interest rates or to lock in relevant risks on a specified time.