What does a derivative of the interest rate mean?
An interest rate derivative is a security whose value changes based on one or more interest rate changes. Some examples of these are swaps, options, and futures contracts. Institutional investors, banks, companies, and people often use interest rate derivatives as hedges to protect themselves against changes in market interest rates. However, they can also be used to increase or lower the risk profile of the holder or to bet on rate changes.
How to Understand Derivatives of Interest Rates
Most of the time, interest rate contracts are used to protect against interest rate risk or to bet on how interest rates will move. When interest rates change, interest rate risk exists in an interest-bearing asset like a loan or a bond. This is because the value of the asset could change. Many tools have been made to help deal with interest rate risk because interest rate risk management has become critical.
Interest rate derivatives can be very easy or complicated and can be used to raise or lower interest rate exposure. Most of the time, interest rate swaps, caps, collars, and floors are used to deal with interest rates.
Interest-rate futures are also very popular. In this case, the futures contract is between a buyer and a seller who agree to give any interest-bearing asset in the future, like a bond. The future interest rate lets the buyer and seller set the price of an object that earns interest for a future date. Interest rate forwards work like futures but are not traded on the market and can be changed between counterparties.
Swaps of interest rates
The most basic and popular type of interest rate derivative is an interest rate swap. A swap has two parties. Party One gets interest payments based on a rate that changes over time, and Party Two pays interest payments based on a rate that stays the same. Party two gets a stream of payments with a fixed interest rate and sends a stream with a variable rate. The principal amount that both payment streams are built on is the same, and the interest payments are added together. This exchange of cash flows aims to lower the risk of loss and confusion caused by changes in market interest rates.
A swap can also make a person or organization more risky if they choose to get the set rate and pay the floating rate. Companies with a credit rating that lets them issue bonds at a low fixed rate but would instead switch to a floating rate to profit from changes in the market most often use this approach.
Floors and caps
There is a way for a company with a loan with a floating rate to protect itself without switching to a set rate. They can buy an interest rate cap. The user sets the cap at the highest rate they are willing to pay. If the market rate goes above the cap, the cap owner gets payments based on the difference between the cap rate and the market rate. The cost of the cap, or premium, depends on how much higher the safety level is than the current market, the interest rate futures curve, and the maturity of the cap. Caps with longer terms cost more because there is a greater chance that they will be in the money.
A business that gets payments at a flexible rate can buy a floor to protect itself from rates going down. The cost is related to the protection and maturity amounts, just like a cap. Rate risk increases when you sell the cap or floor instead of buying it.
Other Tools for Tracking Interest Rate
Other types of interest rate derivatives are euro strips, which are a strip of futures on the eurocurrency deposit market; swaptions, which let the holder know they can swap if a specific rate level is reached but are not required to; and interest rate call options, which let the holder get payments based on a floating rate and then make payments based on a fixed rate. A forward rate agreement (FRA) is an over-the-counter deal that sets the interest rate that will be paid on a specific date in the future in exchange for a promise to pay interest on a certain amount. People don’t trade the notional amount; instead, they exchange cash based on the difference in rates and the contract’s theoretical value.
Conclusion
A financial contract whose worth is based on an interest rate or an asset that earns interest is called an interest rate derivative. These include interest rate futures, options, swaps, swaptions, and FRAs.
People or businesses exposed to interest rate risk can use these swaps to protect themselves or lower the money they could lose if interest rates change.
