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Interest Rate Derivatives

An Interest Rate Derivative is a derivative whose payments are determined using calculation techniques where the reference product is an interest rate or a set of different interest rates.
authorImagePriyanka Dahima28 May, 2024
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Interest Rate Derivatives

Interest Rate Derivatives: An interest rate derivative is a financial instrument whose value is linked to interest rate or interest rate movements. These may include futures, options or swaps. Interest rate derivatives are often used by institutional investors, banks, companies and individuals to hedge  against changes in market interest rates, but they can also be used to increase or refine the holder's risk profile or to speculate on Interest Rate changes.

Interest Rate Derivatives

An interest rate derivative is a financial contract whose value is based on an underlying interest rate or interest-bearing asset. These may include interest rates, options, swaps, swaps and FRAs. Entities exposed to interest rate risk may use these derivative instruments to hedge or minimize potential losses that may be associated with changes in interest rates. An interest-bearing asset, such as a loan or bond, has an interest bearing quality because the value of the asset can change due to fluctuations in interest rates. Interest rate risk management has become very important, and various instruments have been developed to mitigate interest rate risk.

Types of Interest Rate Derivatives

Here we are sharing the details of the Types of Interest Rate Derivatives -

Interest Rate Swap

A plain vanilla interest rate swap is the simplest and most common interest rate derivative. There are two parties to an exchange: one party receives a stream of interest payments at a variable rate and pays a stream of interest at a fixed rate. The other party receives fixed rate payments and pays floating rate payments. Both payment streams are based on the same nominal capital and interest payments are offset. By exchanging such cash flows, the parties try to reduce uncertainty and the risk of loss due to changes in market interest rates.

Caps and Floors

A variable rate loan company that doesn't want to switch to a fixed rate but wants protection can buy a rate cap. The cap rate is determined by the highest interest rate the borrower is willing to pay; if the market moves above this level, the owner of the cap will receive regular payments based on the spread between the cap and the market rate. The premium, which is the limit price, is based on how high the level of protection is above the current market; future interest rate curve; and deadline; longer periods cost more because there is a greater chance that it will be in the money.

Other Interest Rate Instruments

Less common interest rate derivatives include Eurostrips, which are futures on the euro currency deposit; swaps that give the holder the right, but not the obligation, to enter into a swap when a certain interest rate is reached; and interest rate options, which give the holder the right to receive payments at a floating rate and then make payments at a fixed rate. A forward agreement (FRA) is an over-the-counter contract that specifies an interest rate to be paid at an agreed time in the future to exchange an interest liability for a nominal value. No nominal value is exchanged, but an amount based on exchange rate differences and the nominal value of the contract.

Advantages of Interest Rate Derivatives

  • 91-day government bond yields can be used to hedge against volatile interest rates.
  • Cash settled, allowing investors to trade without the fear of illiquid
  • exposures that could occur if the contracts were physically settled.
  • Securities Tax (STT) is not charged.
  • Low margins are required compared to trading stocks and stock derivatives.
  • The new product is traded in the currency segment of the exchange, so there is no need for new formalities for a new account.
  • Greater market reach allows greater liquidity.
  • The Exchange platform provides protection against counterparty default risk.
  • Better transparency with an automatic anonymous order matching system and invoicing.
  • Targeted discount delivery is possible on the exchange platform.
  • A large number of experienced participants can trade using electronic online trading systems, resulting in efficient price discovery.

Interest Rate Derivatives FAQs

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