What Are Interest Rate Derivatives?
An interest rate derivative is a financial instrument whose value is linked to the movements of an interest rate or rates. These may include futures, options, or swaps contracts. Commonly used by institutional investors, banks, companies, and individuals, interest rate derivatives serve as hedges to protect against changes in market interest rates. Additionally, they can be used to adjust one’s risk profile or speculate on interest rate trends.
Key Takeaways
- Interest rate derivatives are financial contracts based on underlying interest rates or interest-bearing assets.
- Instruments in this category include interest rate futures, options, swaps, swaptions, and forward rate agreements (FRAs).
- These derivatives are instrumental for entities to hedge against interest rate risks or minimize potential losses associated with changing interest rates.
Understanding Interest Rate Derivatives
Primarily, interest rate derivatives are employed to hedge against interest rate risk or to speculate on future rate movements. Interest rate risk exists in an interest-bearing asset, such as a loan or a bond, because of the possibility of a change in the asset’s value due to rate variability. The realm of interest rate risk management has grown significantly, resulting in the creation of various instruments to address such risks.
These derivatives can vary from simple to highly complex configurations, and they can either reduce or increase interest rate exposure. Among the most frequently used interest rate derivatives are interest rate swaps, caps, floors, and collars (which create both a cap and a floor).
Interest rate futures are another popular form of these derivatives. Here, a futures contract exists between a buyer and seller agreeing to the future delivery of any interest-bearing asset, such as a bond. This allows the buyer and seller to lock in the price of the interest-bearing asset for a future date. Unlike futures, forwards on interest rates are customizable and traded over-the-counter (OTC).
Interest Rate Swaps
A plain vanilla interest rate swap is the most basic and common type of interest rate derivative. In such a swap, two parties exchange cash flows: one pays a stream of interest based on a floating interest rate, while receiving a fixed-rate payment, and the other party does the inverse. Both payment streams are calculated based on the same notional principal. This setup helps both parties reduce uncertainty and mitigate the threat of loss from fluctuating market interest rates.
Additionally, swaps can be used to enhance an individual’s or institution’s risk profile, especially for entities capable of issuing low-cost fixed-rate bonds but preferring to capitalize on floating rates.
Caps and Floors
A company with a floating rate loan might opt for an interest rate cap if it wants protection without moving to a fixed rate. The cap is set to a ceiling rate that the borrower wishes to avoid; if market rates increase beyond this level, the owner receives periodic payments for the difference. The cap’s cost is influenced by the protection level above the existing market rate, the futures rate curve, and its maturity period, with longer maturities presenting higher costs.
Conversely, a company receiving floating payments can purchase a floor to shield against decreasing rates. Owning a floor operates similarly to a cap, in terms of cost determinants. Selling the cap or floor, instead of buying, increases rate risk.
Other Interest Rate Instruments
While less common, other interest rate derivatives include eurostrips (strips of futures on the eurocurrency deposit market), swaptions (which allow the right but not the obligation to enter into a swap at a preset rate), and interest rate call options (enabling the holder to receive floating rate payments and make fixed-rate payments).
A forward rate agreement (FRA) is another OTC contract that sets an interest rate payment in the future. The notional amount isn’t exchanged; rather, a cash settlement based on rate differentials is made to settle the contract.
Related Terms: floating interest rate, notional principal, fixed rate, hedging strategies.
