Premium
Premium is the price of buying a future option. Premium is the only cost of hedging funds to the option holder. Premium is the profit to the future option writer.
Future options are generally called as options.
Cap
Cap sets the upper limit to interest rate movement.
Organization willing to borrow in future can reduce its risk by purchasing cap to protect against risk of increase in interest rate. Option writer will increase its profits by selling cap.
Similarly, organization willing to invest in future can reduce its cost and benefit of option by selling cap. Option writer will reduce its profits and risk by purchasing cap.
Floor
Floor sets the lower limit to interest rate movement.
Organization willing to borrow in future can reduce its cost and benefit of option by selling floor to reduce the cost of option. Option writer will reduce its profits and risk by purchasing floor.
Organization willing to invest in future can reduce its risk by purchasing floor to protect against risk of decrease in interest rate. Option writer will increase its profits by selling floor.
Cap and floor are extremely opposite to each other.
Collar
Negotiating cap and floor as a package is known as collar.
Savings from collar will be less than cost of premium. As residual amount paid, will be profit to the option writer.
