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Interest Rate Derivatives explained in detail

October 21, 2015

In my previous article I talked about one of the important type of OTC derivative that is Credit Derivative . Today I shall be explaining another important type namely the Interest Rate Derivatives in this article.

Interest rate derivatives Definition

It is defined by Wikipedia as the derivative instrument in which the underlying asset has the right to pay or receive money at a given rate of interest. In simple words, it is a financial instrument based on an underlying, the value of which is impacted by any change in the interest rates.

Interest rates can be Treasury (which includes instruments offered by the government in the denominated currency), Interbank (like LIBOR, EURIBOR) and Repo Rates (repurchase agreement).

Types of Interest rate derivatives

A) Vanilla

B) Quasi Vanilla

C) Exotic derivatives

In context to the degree of complexity, there are three types of interest rate derivatives, each of which can be distinguished based on the extent of liquidity, tradability and complexity.

Where the vanilla type is the most basic and standard type of interest rate derivative with maximum liquidity, Quasi vanilla is the next level after vanilla type and is fairly liquid. The exotic derivatives are the most illiquid, more complex compared to the commonly traded vanilla derivatives.

Examples of types of interest rate derivatives

Swaption:

It gives a buyer the option to purchase interest rate swap agreement at a given time. The buyer pays for the right to purchase but is not obligated to do the same.

Interest rate swaps (IRS):

It is an agreement to exchange series of fixed cash flows with floating cash flows. Each participating party agrees to pay a fixed or floating rate in a particular currency. These are used to convert liability or investment from fixed to floating and vice versa. Initially valued at zero, then the IRS are valued as the difference between fixed rate and floating rate of the bond.

Interest rate swaption:

It is defined as an agreement between two parties to exchange fixed interest obligation for a floating rate obligation over a period of time.

Interest rate future:

It is defined as the contract between buyer and seller agreeing to future delivery of any interest bearing underlying asset.

Forward rate option:

It is a financial contract between two parties to exchange interest payments based on a notional principal for a specified future period. It is used by the corporates to hedge their future loan exposure against rising rates. Interbank participants use it for speculative purposes.

Interest rate cap / floor:

It is designed to provide protection against upward interest rate movements by putting a ceiling on the movements. On the other hand, interest rate floor, protects the holder from adverse downward movement in the interest rates.

In arrears swap:

It is a form of interest rate swap in which the floating payment is based on the interest rate at the end of the specified period. It is also known as delayed reset swap.

Targeted accrual redemption note (TARN):

It is calculated based on a variation of the LIBOR formula which provides a guaranteed sum of coupons. (as per Investopedia). They typically have coupon payments that are based on an inverse LIBOR calculation.

Cross currency swaption:

It is an agreement between two parties to exchange interest payments and principal on loans denominated in two different currencies. These are used to convert the liability/investment  in one currency to another currency. The valuation is similar to IRS.

Bermudan Swaption:

Swaption gives the right and not obligation to enter into underlying swap. Bermudan swaption is different from other forms of swaption, as the holder gets the right to enter into an interest rate swap at each exercise date provided it is not exercised earlier.

Interest rate derivatives are also categorized into short term (underlying instrument has maturity of less than a year) and long term (underlying instrument has maturity of more than a year).

There can spot and future contracts on the underlying securities of the interest rate derivative. There can be three types of transactions in the futures market namely speculation, arbitrage and hedging.

  • Speculation is purely on the prediction about the market. Accordingly, the speculator will make or break money as per the buying/selling done in relation to the movement of the interest rate predicted.
  • Arbitrage has two positions taken one in spot and other in future, making a profit by the difference between the two.
  • Hedging is majorly done to prevent any unfavorable movement in the interest rates.

Advantages of Interest rate derivatives

  1. Interest rate derivatives are opted for adjustments of portfolios
  2. They are more liquid compared to the underlying instrument
  3. They help in lowering the cost of funding
  4. Speculative positions can be taken in context to future movement in interest rates
  5. They can provide yield irrespective of the market conditions
  6. Market participants use interest rate derivatives either to hedge the risk or take future positions
  7. It helps in mitigating the risk from unpredictable interest rate swings (risk diversification instrument)

Disadvantages of Interest rate derivatives

  1. Risk of loss is unlimited
  2. Prices are generally not available publicly
  3. Complex structure of the derivative can make it difficult to gauge the risk and calculate the yield

Conclusion

Interest rate derivatives are one of the apt methods to mitigate the risk associated with the underlying based on the fluctuating interest rates. A well defined form of this derivative can be used to diversify the risk and give strong yields from the underlying.

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