Interest rate derivative

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An interest rate derivative is a derivative where the underlying asset is the right to pay or receive a (usually notional) amount of money at a given interest rate.

The interest rate derivatives market is the largest derivatives market in the world. Market observers estimate that $60 trillion dollars by notional value of interest rate derivatives contract had been exchanged by May 2004^{[citation needed]}. Measuring the size of the market is difficult because trading in the interest rate derivative market is largely done over-the-counter. According to the International Swaps and Derivatives Association, 80% of the world's top 500 companies as of April 2003 used interest rate derivatives to control their cashflows. This compares with 75% for foreign exchange options, 25% for commodity options and 10% for stock options.

Contents 1 Types of Interest Rate Derivatives 2 Examples of Interest Rate Derivatives 2.1 Interest Rate Cap 2.2 Range Accrual Note 2.3 Bermuda Swaption 3 References

[edit] Types of Interest Rate Derivatives

These are the basic building blocks for most interest rate derivatives and can be described as vanilla (simple, basic derivative structures) products:

• Interest Rate Swap
• Interest Rate Cap or Floor
• Interest Rate Swaption
• Bond option
• Forward rate agreement
• Interest Rate futures

Building off of these structures are more exotic interest rate derivatives such as:

• Range Accrual Swaps/Notes/Bonds
• In-Arrears Swap
• Constant Maturity or Constant Treasury Swap
• Interest Rate Swap based upon two floating interest rates

As well as non-European variants of the interest rate swaptions such as Bermudan or American-style swaptions which offer the holder the option of exercise times other than at the option's maturity.

These structures are popular for investors with customized cashflows needs or specific views on the interest rate movements (such as volatility movements or simple directional movements).

[edit] Examples of Interest Rate Derivatives

[edit] Interest Rate Cap

An interest rate cap is designed to hedge a company’s exposure to sustained interest rate movements only. It establishes a maximum total dollar interest amount the hedger will pay out over the life of the cap. By hedging dollar interest payments over a longer time horizon, a company hedges its core interest rate exposure at the lowest cost.

[edit] Range Accrual Note

Suppose a manager wished to take a view that volatility of interest rates will be low. He or she may gain extra yield over a regular bond by buying a range accrual note instead. This note pays interest only if the floating interest rate (i.e.London Interbank Offered Rate) stay within a pre-determined band. This note effectively contains an embedded option which is, in this case, the buyer of the note has sold to the issuer. This option adds to yield of the note. In this way, if volatility remains low, the bond yields more than a standard bond.

[edit] Bermuda Swaption

Suppose a fixed-coupon callable bond was brought to the market by a company. The issuer however, entered into an interest rate swap to convert the fixed coupon payments to floating payments (based on LIBOR maybe). Since it is callable however, the issuer may redeem the bond back from investors at certain dates during the life of the bond. If called, this would leave the issuer still with the interest rate swap however. Therefore, the issuer also enters into Bermuda swaption when the bond is brought to market with exercise dates equal to callable dates for the bond. If the bond is called, the swaption is exercised, effectively canceling the swap leaving no more interest rate exposure for the issuer.

[edit] References

• Hull, John C. (2005) Options, Futures and Other Derivatives, Sixth Edition. Prentice Hall. ISBN 0131499084
• Marhsall, John F (2000). Dictionary of Financial Engineering. Wiley. ISBN 0471242918