Interest rate derivative

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 2004Fact|date=March 2007. 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.

Types

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

*Interest rate swap (fixed-for-floating)
*Interest rate cap or Floor
*Interest rate swaption
*Bond option
*Forward rate agreement
*Interest rate future
*Money market instruments
*Cross currency swap (see Forex swap)

The next intermediate level is a quasi-vanilla class of (fairly liquid) derivatives, examples of which are:
*Range accrual Swaps/Notes/Bonds
*In-arrears Swap
*Constant maturity swap (CMS) or constant treasury swap (CTS) derivatives (swaps, caps, floors)
*Interest rate swap based upon two floating interest rates

Building off these structures are the exotic interest rate derivatives (least liquid, traded over the counter), such as:
*Power Reverse Dual Currency note (PRDC or Turbo)
*Target redemption note (TARN)
*CMS steepener
*Snowball
*Inverse floater
*Strips of Collateralized mortgage obligation
*Ratchet caps and floors
*Bermudan swaptions
*Cross currency swaptions

Most of the exotic interest rate derivatives can be classified as to have two payment legs: funding leg and exotic coupon leg. A funding leg usually consists of series of fixed coupons or floating coupons (LIBOR) plus fixed spread. An exotic coupon leg typically consists of a functional dependence on the past and current underlying indices (LIBOR, CMS rate, FX rate) and sometimes on its own past levels, as in Snowballs and TARNs. The payer of the exotic coupon leg usually has a right to cancel the deal on any of the coupon payment dates, resulting in the so-called Bermudan exercise feature. There may also be some range-accrual and knock-out features inherent in the exotic coupon definition.

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

Modeling of interest rate derivatives (see Mathematical Finance) is usually done on a time-dependent multi-dimensional tree built for the underlying risk drivers, examples of which are domestic/foreign short rates and Forex rate.

Example of Interest Rate Derivatives

Interest Rate Cap

An interest rate cap is designed to hedge a company’s maximum exposure to upward interest rate movements. It establishes a maximum total dollar interest amount the hedger will pay out over the life of the cap. The interest rate cap is actually a series of individual interest rate caplets, each being an individual option on the underlying interest rate index. The interest rate cap is paid for upfront, and then the purchaser realizes the benefit of the cap over the life of the instrument.

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) stays 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 the yield of the note. In this way, if volatility remains low, the bond yields more than a standard bond.

Bermudan 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 Bermudan 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.

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

External links

* [http://www.financial-edu.com/basic-fixed-income-derivative-hedging.php Basic Fixed Income Derivative Hedging] - Article on Financial-edu.com.