An interest rate derivative is a financial contract between two parties to exchange interest rate related future payments over a set of future times. The payments are derived from an underlying interest rate. Derivatives in interest rate markets bear interest rate risk that is the risk arising due to interest rate fluctuation. Interest rate risk is an important part of market risk.
Interest rate market is a key element of the global financial market. Financial market provides a public place for participants to trade fairly. It allows people to invest their money or acquire capital or offset risk.
The following products are most heavily traded in the interest rate market.
1. Interest Rate Swap
Interest rate swaps are the most popular OTC derivatives that are generally used to manage exposure to fluctuations in interest rates. Swaps can be also used to obtain a marginally lower interest rate. Thus they are often utilized by a firm that can borrow money easily at one type of interest rate but prefers a different type. They also allow investors to adjust interest rate exposure and offset interest rate risks. Speculators use swaps to speculate on the movement of interest rates. More and more swaps are cleared through central counterparties nowadays (CCPs).
2. Forward Rate Agreement
An FRA can be used to hedge future interest rate or exchange rate exposure. The buyer hedges against the risk of rising interest rate whereas the seller hedges against the risk of falling interest rates. In other words, the buyer locks in the interest rate to protect against the increase of interest rates while the seller protects against the possible decrease of interest rates. A speculator can also use FRAs to make bets on future directional changes in interest rates. Market participants can also take advantage of price differences between an FRA and other interest rate instruments. FRAs are money market instruments that are liquid in all major currencies.
An interest rate swaption or interest rate European swaption is an OTC option that grants its owner the right but not the obligation to enter an underlying interest rate swap. There are two types of swaptions: a payer swaption and a receiver swaption. A payer swaption is also called a right-to-pay swaption that allows its holder to exercise into a swap where the holder pays fixed rates and receives floating rates. A receiver swaption is also called right-to-receive swaption that allows its holders to exercise into a swap where the holder receives fixed rates and pays floating rates. Swaptions provide clients with a guarantee that the fixed rate of interest they will pay at some of future time will not exceed certain level.
4. Cap and Floor
Interest rate caps are frequently purchased by issuers of floating rate debt who wish to protect themselves from the increased financing costs that would result from a rise in interest rates. Investors use caps to hedge against the risk associated with floating interest rate and will benefit from any risk in interest rates above the strike. The holder gets a payment when the underlying interest rate exceeds a specified strike rate.
5. Interest Rate Futures
Interest rate futures are used to hedge against interest rate risk. Investors can use Eurodollar futures to secure an interest rate for money it plans to borrow or lend in the future. Interest rate futures are mainly listed for 3-month Eurodollar, 1-month LIBOR, 1-month banker’s acceptance futures and 3-month banker’s acceptance futures.
6. Interest Rate Future Option
An interest rate future option gives the holder the right but not the obligation to buy or sell an interest rate future at a specified price on a specified date. It is usually traded in an exchange. The buyer normally can exercise the option on any business day (American style) prior to expiration by giving notice to the exchange. Option sellers (writer) receive a fixed premium upfront and in return are obligated to buy or sell the underlying asset at a specified price.
7. Bermudan Swaption
An interest rate Bermudan swaption gives the holder the right but not the obligation to enter an interest rate swap at predefined dates. It is one of the fundamental ways for an investor to enter a swap. Comparing to regular swaptions, Bermudan swaptions provide market participants more flexibility and control over the exercising of an option and less restriction.
8. Cancelable Swap
A cancelable swap provides the right but not the obligation to cancel the interest rate swap at predefined dates. Most commonly traded cancelable swaps have multiple exercise dates. Given its Bermudan style optionality, a cancelable swap can be represented as a vanilla swap embedded with a Bermudan swaption. Therefore, it can be decomposed into a swap and a Bermudan swaption. Most Bermudan swaptions in a bank book actually come from cancelable swaps.
9. Amortizing Cap
An amortizing cap is primarily used to hedge loans whose principal declines on a scheduled basis while an accreting cap is primarily used to hedge construction loans whose principal increases on a scheduled basis to meet the expanding working capital requirements. Amortizing caps are frequently purchased by issuers of floating rate debt where the loan principal declines during the life. Similarly accreting caps are frequently purchased by issuers of floating rate debt where the loan principal increases during the life. The holders wish to protect themselves from the increased financing costs that would result from a rise in interest rates.
10. Amortizing Swap
The notional principal of an amortizing swap is tied to an underlying financial instrument with a declining principal, such as a mortgage. On the other hand, the notional amount of an accreting swap is tied to an underlying instrument with an increasing principal, such as a construction fund. The notional principal schedule of an amortizing or an accreting swap may decrease or increase at the same rate as the underlying instrument. Both amortizing and accreting swaps can be used to reduce or increase exposure to fluctuations in interest rates.
11. Compound Swap
A compounding swap is an interest rate swap in which interest, instead of being paid, compounds forward until the next payment date. Compounding swaps can be valued by assuming that the forward rates are realized. Normally the calculation period of a compounding swap is smaller than the payment period. For example, a swap has 6-month payment period and 1-month calculation period (or 1-month index tenor). An overnight index swap (OIS) is a typical compounding swap
12. Basis Swap
A basis swap can be used to limit interest rate risk that a firm faces as a result of having different lending and borrowing rates. Basis swaps help investors to mitigate basis risk that is a type of risk associated with imperfect hedging. Firms also utilize basis swaps to hedge the divergence of different rates. Basis swaps could involve many different kinds of reference rates for the floating payments, such as 3-month LIBOR, 1-month LIBOR, 6-month LIBOR, prime rate, etc. There is an active market for basis swaps.
13. Capped Swap
A capped swap can be decomposed into a swap and a cap whereas a floored swap can be decomposed into a swap and a floor. Given the optionality, an up-front fee or premium has to be paid by the floating rate payer for a capped swap and an up-front fee or premium has to be paid by the floating rate receiver for a floored swap.
14. FX Asian Option
Asian FX options allow the buyer to purchase or sell the underlying foreign exchange rate at the average rate instead of the spot rate. Asian options are commonly seen options over the OTC markets. Average rate options are less expensive than regular options and are arguably more appropriate than regular options for meeting some of investment needs. Average can be calculated in a number of ways (daily, weekly, monthly, etc.).
Asian options have relatively low volatility due to the averaging mechanism. They are used by traders who are exposed to the underlying asset over a period of time. The arithmetic average rate options are generally used to smooth out the impact from high volatility periods or prevent rate manipulation near the maturity date, which makes the options less expensive.
15. FX Forward
A currency forward or FX forward contract is an agreement that allows the buyer to lock in an exchange rate the day on which the agreement is signed for a transaction that will be completed later. Forward contracts are one of the main methods used to hedge against exchange rate volatility, as they avoid the impact of currency fluctuation over the period covered by the contract.
A currency forward or FX forward is a contract agreement between two parties to exchange a certain amount of a currency for another currency at a fixed exchange rate on a fixed future date. Currency forwards are effective hedging vehicles that allow buyers to indicate the exact amount to be exchanged and the date on which to settle in the forward contract.
16. FX Futures
A currency future or an FX future is a future contract between two parties to exchange one currency for another at a fixed exchange rate on a fixed future date. Currency futures are one of the main methods used to hedge against exchange rate volatility, as they avoid the impact of currency fluctuation over the period covered by the contract.
Because currency futures contracts are marked-to-market daily, investors can exit their obligation to buy or sell the currency prior to the contract’s delivery date. Future market participants and speculators usually close out their positions before the date of settlement, so most contracts do not tend to last until the date of delivery. Currency futures contracts are legally binding and counterparties that are still holding the contracts on the expiration date must trade the currency pair at a specified price on the specified delivery date.
17. FX Option
A currency option, also known as FX Option, is a derivative contract that grants the buyer the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified future date. The FX options market is the deepest, largest and most liquid market for options of any kind. Most FX derivatives trading is over the counter (OTC) and is lightly regulated.
There are call options and put options. Also a currency option could be European style or American style. Call options provide the holder the right but not the obligation to purchase an underlying currency at a specified FX rate on a future date, while Put options give the holder the right to sell an underlying currency at a specified FX rate on a future date. A European option can be exercised only at the expiration date of the option, whereas an American option can be exercised anytime during its life.
18. FX Swap
An FX swap or currency swap agreement is a contract in which both parties agree to exchange one currency for another currency at a spot FX rate. The agreement also stipulates to re-exchange the same amounts at a certain future date also at a forward FX rate. Many people confuse currency swaps with cross currency swaps. They are totally different. A cross currency swap is an interest rate swap in which two parties to exchange interest payments and principal on loans denominated in two different currencies.
In a currency swap, one party simultaneously borrows one currency and lends another currency to a second party. The repayment obligation is used as collateral and the amount of repayment is fixed at the FX forward rate. FX swaps can be considered riskless collateralized borrowing/lending. The contract virtually allows you to utilize the funds you have in one currency to fund obligations denominated in a different currency, without incurring foreign exchange risk.
19. FX Touch
A touch option is the sort of option that promises a payout once the price of an underlying asset reaches or passes a predetermined level. Touch options allow investors to choose the target price, time to expiration, and the premium to be received when the target price is reached.
There are only two possible outcomes. If the barrier is broken a trader will receive the agreed full payout. If the barrier isn’t broken, the trader will lose the premium paid to the broker. Unlike vanilla calls and puts, touch options allow investors to profit from a simplified yes-or-no market forecast. Like regular call and put options, most touch option trades can be closed before expiration for a profit or a loss depending on how close the underlying market or asset is to the target price.
20. Yield Curve Introduction
The term structure of interest rates, also known as zero curve, is defined as the relationship between the zero-to-maturity on a zero coupon bond and the bond’s maturity. Zero curves play an essential role in the valuation of all financial products.
21. Curve Construction
Zero curves can be derived from government bonds or LIBOR/swap instruments. The LIBOR/swap term structure offers several advantages over government curves, and is a robust tool for pricing and hedging financial products. Correlations among governments and other fixed-income products have declined, making the swap term structure a more efficient hedging and pricing vehicle.