Interest rate derivative
Encyclopedia
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 2009 were US$437 trillion for OTC
interest rate contracts, and US$342 trillion for OTC
interest rate swap
s. 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 option
s, 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 rate
s and foreign exchange market
rates, and incorporating delivery- and day count convention
s; see Short-rate model. Specialised simulation models are also often used.
):
" 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.
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.
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.
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
where the underlying asset is the right to pay or receive a notional amount
Notional amount
The notional amount on a financial instrument is the nominal or face amount that is used to calculate payments made on that instrument...
of money
Money
Money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given country or socio-economic context. The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value; and, occasionally in the past,...
at a given interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
. 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
Over-the-counter (finance)
Within the derivatives markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading....
; see financial engineering.
The interest rate derivatives market
Derivatives market
The derivatives market is the financial market for derivatives, financial instruments like futures contracts or options, which are derived from other forms of assets....
is the largest derivatives market in the world. The Bank for International Settlements
Bank for International Settlements
The Bank for International Settlements is an intergovernmental organization of central banks which "fosters international monetary and financial cooperation and serves as a bank for central banks." It is not accountable to any national government...
estimates that the notional amount
Notional amount
The notional amount on a financial instrument is the nominal or face amount that is used to calculate payments made on that instrument...
outstanding in June 2009 were US$437 trillion for OTC
Over-the-counter (finance)
Within the derivatives markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading....
interest rate contracts, and US$342 trillion for OTC
Over-the-counter (finance)
Within the derivatives markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading....
interest rate swap
Interest rate swap
An interest rate swap is a popular and highly liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate or from one floating rate to another...
s. According to the International Swaps and Derivatives Association
International Swaps and Derivatives Association
The International Swaps and Derivatives Association is a trade organization of participants in the market for over-the-counter derivatives....
, 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 option
Foreign exchange option
In finance, a foreign-exchange option is a derivative financial instrument that gives the owner 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 date.The FX options market is the deepest, largest and...
s, 25% for commodity
Commodity
In economics, a commodity is the generic term for any marketable item produced to satisfy wants or needs. Economic commodities comprise goods and services....
options and 10% for stock options.
Modeling of interest rate derivatives is usually done on a time-dependent multi-dimensional Lattice
Lattice model (finance)
In finance, a lattice model can be used to find the fair value of a stock option; variants also exist for interest rate derivatives.The model divides time between now and the option's expiration into N discrete periods...
("tree") built for the underlying
Underlying
In finance, the underlying of a derivative is an asset, basket of assets, index, or even another derivative, such that the cash flows of the derivative depend on the value of this underlying...
risk drivers, usually domestic or foreign short rate
Short rate
Short rate may refer to:*Short rate cancellation Penalty method of calculating return premium of an insurance policy...
s and foreign exchange market
Foreign exchange market
The foreign exchange market is a global, worldwide decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends...
rates, and incorporating delivery- and day count convention
Day count convention
In finance, a day count convention determines how interest accrues over time for a variety of investments, including bonds, notes, loans, mortgages, medium-term notes, swaps, and forward rate agreements . This determines the amount transferred on interest payment dates, and also the calculation of...
s; see Short-rate model. Specialised simulation models are also often used.
Vanilla
The basic building blocks for most interest rate derivatives can be described as "vanilla" (simple, basic derivative structures, usually most liquidMarket liquidity
In business, economics or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value...
):
- Interest rate swapInterest rate swapAn interest rate swap is a popular and highly liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate or from one floating rate to another...
(fixed-for-floating) - Interest rate cap or interest rate floor
- Interest rate swaptionSwaptionA swaption is an option granting its owner the right but not the obligation to enter into an underlying swap. Although options can be traded on a variety of swaps, the term "swaption" typically refers to options on interest rate swaps....
- Bond optionBond optionIn finance, a bond option is an option to buy or sell a bond at a certain price on or before the option expiry date. These instruments are typically traded OTC....
- Forward rate agreementForward rate agreementIn finance, a forward rate agreement is a forward contract, an over-the-counter contract between parties that determines the rate of interest, or the currency exchange rate, to be paid or received on an obligation beginning at a future start date. The contract will determine the rates to be used...
- Interest rate futureInterest rate futureAn interest rate futures is a financial derivative with an interest-bearing instrument as the underlying asset.Examples include Treasury-bill futures, Treasury-bond futures and Eurodollar futures....
- Money marketMoney marketThe money market is a component of the financial markets for assets involved in short-term borrowing and lending with original maturities of one year or shorter time frames. Trading in the money markets involves Treasury bills, commercial paper, bankers' acceptances, certificates of deposit,...
instruments - Cross currency swap (see Forex swapForex swapIn finance, a forex swap is a simultaneous purchase and sale of identical amounts of one currency for another with two different value dates .; see Foreign exchange derivative.-Structure:...
)
Quasi-vanilla
The next intermediate level is a quasi-vanilla class of (fairly liquid) derivatives, examples of which are:- Range accrualRange accrualIn finance, a range accrual is a type of derivative product very popular among structured-note investors. It is estimated that more than USD 160 billions of Range Accrual indexed on interest rates only have been sold to investors since 2004...
swaps/notes/bonds - In-arrears swap
- Constant maturity swapConstant maturity swapA constant maturity swap, also known as a CMS, is a swap that allows the purchaser to fix the duration of received flows on a swap.The floating leg of an interest rate swap typically resets against a published index...
(CMS) or constant treasury swap (CTS) derivatives (swaps, caps, floors) - Interest rate swapInterest rate swapAn interest rate swap is a popular and highly liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate or from one floating rate to another...
based upon two floating interest rates
Exotic derivatives
Building off these structures are the "exoticExotic option
In finance, an exotic option is a derivative which has features making it more complex than commonly traded products . These products are usually traded over-the-counter , or are embedded in structured notes....
" 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 http://www.risk.net/asia-risk/feature/1496874/rate-steepeners-rise
- Snowball http://www.fincad.com/derivatives-resources/wiki/snowballs.aspx
- Inverse floater
- Strips of Collateralized mortgage obligationCollateralized mortgage obligationA collateralized mortgage obligation is a type of financial debt vehicle that was first created in 1983 by the investment banks Salomon Brothers and First Boston for U.S. mortgage lender Freddie Mac. A collateralized mortgage obligation (CMO) is a type of financial debt vehicle that was first...
- Ratchet caps and floors
- Bermudan swaptions
- Cross currency swaptions
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.
- 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.
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 yieldYield (finance)
In finance, the term yield describes the amount in cash that returns to the owners of a security. Normally it does not include the price variations, at the difference of the total return...
over a regular bond
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
by buying a range accrual note
Note
In music, the term note has two primary meanings:#A sign used in musical notation to represent the relative duration and pitch of a sound;#A pitched sound itself....
instead. This note pays interest only if the floating interest rate (i.e.London Interbank Offered Rate
London Interbank Offered Rate
The LIBOR rate is the average interest rate that leading banks in London charge when lending to other banks. It is an acronym for London Interbank Offered Rate Banks borrow money for one day, one month, two months, six months, one year etc. and they pay interest to their lenders based on...
) stays within a pre-determined band. This note effectively contains an embedded option
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
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
Volatility (finance)
In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...
remains low, the bond yields more than a standard bond.
Bermudan swaption
Suppose a fixed-coupon callable bondCallable bond
A callable bond is a type of bond that allows the issuer of the bond to retain the privilege of redeeming the bond at some point before the bond reaches the date of maturity. In other words, on the call date, the issuer has the right, but not the obligation, to buy back the bonds from the bond...
was brought to the market by a company. The issuer however, entered into an interest rate swap
Interest rate swap
An interest rate swap is a popular and highly liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate or from one floating rate to another...
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
Interest rate swap
An interest rate swap is a popular and highly liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate or from one floating rate to another...
. Therefore, the issuer also enters into Bermudan swaption
Swaption
A swaption is an option granting its owner the right but not the obligation to enter into an underlying swap. Although options can be traded on a variety of swaps, the term "swaption" typically refers to options on interest rate swaps....
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.
Further reading
- 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
- Basic Fixed Income Derivative Hedging - Article on Financial-edu.com.
- Interest Rate Modeling by L. Andersen and V. Piterbarg