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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 fina ...
, 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, th ...
, 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 adjoini ...
or speculate on the movement of interest rates.
Modeling A model is an informative representation of an object, person or system. The term originally denoted the plans of a building in late 16th-century English, and derived via French and Italian ultimately from Latin ''modulus'', a measure. Models c ...
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 In finance, a derivative is a contract that ''derives'' its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the "underlying". Derivatives can be use ...
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 asp ...
rates, and incorporate delivery- and
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 (FRAs). This determines the number of days b ...
s. The
Heath–Jarrow–Morton framework The Heath–Jarrow–Morton (HJM) framework is a general framework to model the evolution of interest rate curves – instantaneous forward rate curves in particular (as opposed to simple forward rates). When the volatility and drift of the in ...
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.


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;
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. Types of ...
s, 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, ...
(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 and ...
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 thr ...
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 2012Bank 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 swap 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 with ...
s. According to the
International Swaps and Derivatives Association International is an adjective (also used as a noun) meaning "between nations". International may also refer to: Music Albums * ''International'' (Kevin Michael album), 2011 * ''International'' (New Order album), 2002 * ''International'' (The T ...
, 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 In finance, a foreign exchange option (commonly shortened to just FX option or currency option) is a derivative financial instrument that gives the right but not the obligation to exchange money denominated in one currency into another currency at ...
s, 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 dat ...
s.


See also

*
Financial modeling Financial modeling is the task of building an abstract representation (a model) of a real world financial situation. This is a mathematical model designed to represent (a simplified version of) the performance of a financial asset or portfolio ...
*
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 with ...


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 Modeling
by L. Andersen and V. Piterbarg
Pricing and Trading Interest Rate Derivatives
by J H M Darbyshire
Online Analytics and Portfolio Management Tools
by OCM Solutions Inc. {{DEFAULTSORT:Interest Rate Derivative Derivatives (finance)