An interest rate derivative is a derivative which has as an ability to pay or receive a given amount of money at a given interest rate. Interest rate derivatives are the most popular kind of derivative, and include interest rate swaps and forex swaps . It is a derivative where the underlying asset is the right to pay or receive a notional amount of money at a given interest rate. The interest rate derivatives market is the largest derivatives market in the world.
Types
These are the basic building blocks for most interest rate derivatives and can be described as vanilla (simple, basic derivative structures, usually most liquid) products :
* Interest rate swap (fixed-for-floating)
* Interest rate cap or interest rate floor
* Interest rate swap ion
* Bond option
* Forward rate agreement
* Interest rate future
* Money market instruments
* Cross currency swap
IMPORTANT EXAMPLES:
Interest rate 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 yield over a regular bond by buying a range accrual note instead. This note pays interest only if the floating interest 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 swap ion
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. 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.