Interest rate derivative

An interest rate derivative is a derivative where the underlying asset is the right to pay or receive a notional amount of money at a given interest rate. 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) and are therefore usually traded OTC; see financial engineering.

The interest rate derivatives market is the largest derivatives market in the world. The Bank for International Settlements estimates that the notional amount outstanding in June 2012 [1] were US$494 trillion for OTC interest rate contracts, and US$342 trillion for OTC interest rate swaps. 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.

Modeling of interest rate derivatives is usually done on a time-dependent multi-dimensional Lattice ("tree") built for the underlying risk drivers, usually domestic or foreign short rates and foreign exchange market rates, and incorporating delivery- and day count conventions; see Short-rate model. Specialised simulation models are also often used.

Types

Vanilla

The basic building blocks for most interest rate derivatives can be described as "vanilla" (simple, basic derivative structures, usually most liquid):

Quasi-vanilla

The next intermediate level is a quasi-vanilla class of (fairly liquid) derivatives, examples of which are:

Exotic derivatives

Building off these structures are the "exotic" interest rate derivatives (least liquid, traded over the counter), such as:

Most of the exotic interest rate derivatives are structured as swaps or notes, and can be classified as having two payment legs: a funding leg and an exotic coupon leg.

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 contract.

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, 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 (perhaps based on LIBOR). 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 still leave the issuer with the interest rate swap. 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.

See also

References

  1. Bank for International Settlements "Semiannual OTC derivatives statistics" at end-June 2012. Retrieved 5 July 2013.
  2. "Snowballs". FINCAD. Retrieved 24 July 2015.
  3. Levine, Matt (2014-05-02). "Portuguese Train Company Was Run Over by a Snowball". Bloomberg. Retrieved 24 July 2015.

Further reading

External links

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