Interest Rate and Derivatives
How many types of Interest Rate derivatives are there?
Written by: James Brock
What is an Interest Rate Derivative?
Understanding Interest Rate Derivatives
Interest rate derivatives are most often used to hedge against interest rate risk, or else to speculate on the direction of future interest rate moves. Interest rate risk exists in an interest-bearing asset, such as a loan or a bond, due to the possibility of a change in the asset’s value resulting from the variability of interest rates. Interest rate risk management has become very important, and assorted instruments have been developed to deal with interest rate risk.
Interest rate derivatives can range from simple to highly complex; they can be used to reduce or increase interest rate exposure. Among the most common types of interest rate derivatives are interest rate swaps, caps, collars, and floors.
Also popular are interest rate futures. Here the futures contract exists between a buyer and seller agreeing to the future delivery of any interest-bearing asset, such as a bond. The interest rate future allows the buyer and seller to lock in the price of the interest-bearing asset for a future date. Forwards on interest rate operate similarly to futures, but are not exchange-traded and may be customized between counter parties.
Chart Title
Graph on bond price vs yield relationship to show convexity
Interest Rate Swaps
A plain vanilla interest rate swap is the most basic and common type of interest rate derivative. There are two parties to a swap: party one receives a stream of interest payments based on a floating interest rate and pays a stream of interest payments based on a fixed rate. Party two receives a stream of fixed interest rate payments and pays a stream of floating rate payments. Both payment streams are based on the same notional principal, and the interest payments are netted. Through this exchange of cash flows, the two parties aim to reduce uncertainty and the threat of loss from changes in market interest rates.
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