In
finance
Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of f ...
, an interest rate derivative (IRD) is a
derivative
In mathematics, the derivative of a function of a real variable measures the sensitivity to change of the function value (output value) with respect to a change in its argument (input value). Derivatives are a fundamental tool of calculus. ...
whose payments are determined through calculation techniques where the underlying benchmark product is an
interest rate
An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, t ...
, or set of different interest rates. There are a multitude of different
interest rate indices that can be used in this definition.
IRDs are popular with all financial market participants given the need for almost any area of finance to either
hedge
A hedge or hedgerow is a line of closely spaced shrubs and sometimes trees, planted and trained to form a barrier or to mark the boundary of an area, such as between neighbouring properties. Hedges that are used to separate a road from adjoi ...
or
speculate on the movement of interest rates.
Modeling of interest rate derivatives is usually done on a time-dependent multi-dimensional
Lattice ("tree") or using
specialized simulation models. Both are calibrated to the
underlying risk drivers, usually domestic or foreign
short rates and
foreign exchange market
The foreign exchange market (Forex, FX, or currency market) is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. It includes all as ...
rates, and incorporate delivery- and
day count conventions. The
Heath–Jarrow–Morton framework is often used instead of short rates.
Types
The most basic subclassification of interest rate derivatives (IRDs) is to define linear and non-linear.
Further classification of the above is then made to define vanilla (or standard) IRDs and exotic IRDs; see
exotic derivative
An exotic derivative, in finance, is a derivative which is more complex than commonly traded "vanilla" products. This complexity usually relates to determination of payoff; see option style.
The category may also include derivatives with a non-s ...
.
Linear and non-linear
Linear IRDs are those whose net present values (PVs) are overwhelmingly (although not necessarily entirely) dictated by and undergo changes approximately proportional to the one-to-one movement of the underlying interest rate index. Examples of linear IRDs are;
interest rate swaps (IRSs),
forward rate agreements (FRAs),
zero coupon swaps (ZCSs),
cross-currency basis swaps (XCSs) and
single currency basis swaps (SBSs).
Non-linear IRDs form the set of remaining products. Those whose PVs are commonly dictated by more than the one-to-one movement of the underlying interest rate index. Examples of non-linear IRDs are;
swaptions,
interest rate caps and floors and
constant maturity swaps (CMSs). These products' PVs are reliant upon volatility so their pricing is often more complex as is the nature of their risk management.
Vanilla and exotic
The categorisation of linear and non-linear and vanilla and exotic is not universally acknowledged and a number of products might exist that can be arguably assigned to different categories. These terms may also overlap.
"Vanilla", in "vanilla IRSs" and "vanilla swaptions", is often taken to mean the basic, most liquid and commonly traded variants of those products.
Exotic is usually used to define a feature that is an extension to an IRD type. For example, an
in-arrears IRS is a genuine example of an exotic IRS, whereas an IRS whose structure was the same as vanilla but whose start and end dates might be unconventional, would not generally be classed as exotic. Typically this would be referred to as a bespoke IRS (or customised IRS).
Bermudan swaptions are examples of swaption extensions that qualify as exotic variants.
Other products that are generally classed as exotics are
power reverse dual currency note A ''dual-currency note'' (DC) pays coupons in the investor's domestic currency with the notional in the issuer's domestic currency. A ''reverse dual-currency note'' (RDC) is a note which pays a foreign interest rate in the investor's domestic curren ...
(PRDC or Turbo),
target redemption note
Target may refer to:
Physical items
* Shooting target, used in marksmanship training and various shooting sports
** Bullseye (target), the goal one for which one aims in many of these sports
** Aiming point, in field artillery, f ...
(TARN), CMS steepene
Snowball (finance),
Inverse floating rate note, Inverse floater,
Strips of
Collateralized mortgage obligation
A collateralized mortgage obligation (CMO) is a type of complex debt security that repackages and directs the payments of principal and interest from a collateral pool to different types and maturities of securities, thereby meeting investor need ...
, Ratchet caps and floors, and Cross currency swaptions.
Trivia
The interest rate
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.
The market can be divided into two, that for exchange-traded derivatives a ...
is the largest derivatives market in the world. The
Bank for International Settlements
The Bank for International Settlements (BIS) is an international financial institution owned by central banks that "fosters international monetary and financial cooperation and serves as a bank for central banks".
The BIS carries out its work th ...
estimates that the
notional amount
The notional amount (or notional principal amount or notional value) on a financial instrument is the nominal or face amount that is used to calculate payments made on that instrument. This amount generally does not change and is thus referred to a ...
outstanding in June 2012
[Bank for International Settlement]
"Semiannual OTC derivatives statistics"
at end-June 2012. Retrieved 5 July 2013. were US$494 trillion for
OTC interest rate contracts, and US$342 trillion for
OTC interest rate swaps. 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 options, 25% for
commodity
In economics, a commodity is an economic good, usually a resource, that has full or substantial fungibility: that is, the market treats instances of the good as equivalent or nearly so with no regard to who produced them.
The price of a co ...
options and 10% for
stock option
In finance, an option is a contract which conveys to its owner, the ''holder'', the right, but not the obligation, to buy or sell a specific quantity of an underlying asset or instrument at a specified strike price on or before a specified d ...
s.
See also
*
Financial modeling
*
Mathematical finance
Mathematical finance, also known as quantitative finance and financial mathematics, is a field of applied mathematics, concerned with mathematical modeling of financial markets.
In general, there exist two separate branches of finance that require ...
*
Multi-curve framework
In finance, an interest rate swap (IRS) is an interest rate derivative (IRD). It involves exchange of interest rates between two parties. In particular it is a "linear" IRD and one of the most liquid, benchmark products. It has associations wi ...
References
Further reading
*
*
*
*John C. Hull (2005) ''Options, Futures and Other Derivatives'', Sixth Edition. Prentice Hall.
* John F. Marhsall (2000). ''Dictionary of Financial Engineering''. Wiley.
External links
Basic Fixed Income Derivative Hedging- Article on Financial-edu.com.
Interest Rate Modelingby L. Andersen and V. Piterbarg
Pricing and Trading Interest Rate Derivativesby J H M Darbyshire
Online Analytics and Portfolio Management Toolsby OCM Solutions Inc.
{{DEFAULTSORT:Interest Rate Derivative
Derivatives (finance)