Collar

A client is offered a collar structured so that the premium received on the call written exactly pays for the put purchased. The adviser should explain that

1. A.the structure genuinely has no cost, which is why it is described as costless.Wrong. The label refers only to the net cash outlay and says nothing about what has been surrendered.
2. B.the structure removes the downside without any offsetting limitation at all.Wrong. The call written is precisely the offsetting limitation, and it is what funds the floor.
3. C.the client keeps the whole upside, since no cash has left the account.Wrong. The written call transfers the appreciation above its strike whatever the cash flow looked like.
4. D.the cost has been paid in the upside surrendered above the strike of the call.Correct. The appreciation given up is the true price, and it can far exceed a cash premium.

Why: A collar of this kind is described as costless because no net cash leaves the account, but the price has simply been paid in a different currency. The client has sold the appreciation above the call strike in order to buy the floor below the put strike, so the real cost is every dollar the shares might have gained beyond that ceiling. Whether the trade is a good one depends entirely on how much upside is being surrendered and how much protection is being obtained. Describing it to a client as free, without naming what was given up, misstates the economics of the position.

An adviser places a one-year collar on a large single-stock holding for a client. In explaining what the collar does and does not accomplish, the essential point is that it

1. A.converts the concentrated holding into a diversified position for the duration.Wrong. It changes the payoff on the shares while leaving the client holding one company.
2. B.removes the need to monitor the position, since both ends of the outcome are fixed.Wrong. The expiry, the tax position and the eventual disposition all still require attention.
3. C.permanently caps the downside, because the collar can always be renewed on these terms.Wrong. Renewal happens at whatever terms the market offers then, which cannot be known now.
4. D.limits the price exposure for a year but leaves the client concentrated when it expires.Correct. It separates the temporary payoff change from the underlying concentration that survives it.

Why: A collar reshapes the payoff on the shares for a defined period, putting a floor beneath them and a ceiling above them, and it does that without the client selling anything. What it does not do is change what the client owns, so at expiration the position is still a single company held in the same size, with the same business risk and the same concentration. The hedge buys time and limits damage within its term rather than solving the underlying problem. Renewal is possible but only at whatever terms prevail then, which cannot be known when the first collar is written.

A client asks his adviser for a way to remove the downside of his portfolio while keeping the whole of the upside and paying nothing at all. The adviser should explain that

1. A.such a structure exists, in the form of a costless collar.Wrong. That structure is costless in cash only, having sold the upside to pay for the floor.
2. B.such a structure exists, in the form of a protective put funded out of dividends.Wrong. Paying the premium from another source settles the cost rather than removing it.
3. C.the request can be met with index futures, which require no premium to enter.Wrong. Futures cost no premium but remove the upside and the downside together.
4. D.every transfer of risk is paid for, in premium, in forgone upside, or in imperfect cover.Correct. It names the three currencies a hedge can be paid in and insists that one of them applies.

Why: Every hedge transfers risk to a counterparty, and no counterparty accepts risk without compensation, so the question is never whether there is a cost but what form it takes. A purchased put costs a premium, a collar costs the appreciation above the ceiling, a futures hedge costs the entire favourable direction, and a cheaper mismatched hedge costs the client in basis risk when it fails to cover the loss it was bought for. Naming which of those currencies is being paid is the substance of the advice. A structure that appeared to violate this would simply be one whose cost had not yet been identified.

A client holds a very large position in one company with a very low cost basis. Her adviser is weighing a collar against selling part of the position outright. The consideration that most favours the partial sale is that

1. A.a collar defers the tax, and deferral is always to be preferred to paying now.Wrong. Deferral has value but also a price, and here the price is continued concentration.
2. B.a collar cannot be used on a position of that size in any event.Wrong. No size limitation applies; the objection is to what the collar does, not to whether it can be done.
3. C.a sale permanently reduces the exposure, while a collar postpones the decision and expires.Correct. Permanence is exactly the thing the hedge cannot supply, however well it works within its term.
4. D.a sale avoids the tax, whereas the collar accelerates it.Wrong. It inverts the tax picture entirely, since the sale is what triggers the gain.

Why: Two sound principles pull in opposite directions here: deferring a tax preserves capital that would otherwise be paid away, while diversifying removes a risk that no hedge permanently addresses. The collar defers the tax but expires, leaving the client holding the same concentrated position and facing the same decision under whatever market and tax conditions then apply. A partial sale costs tax now and permanently removes that portion of the exposure, which is the one thing the hedge cannot do. Which consideration should win depends on the size of the embedded gain and how much of her total wealth the position represents.