A financial statement or a derivative that is based on underlying asset whose value is affected by changes at any given interest rate is called an interest rate derivative. These structures are commonly used by institutional investors and large banks to handle changes in the movement of interest rates.
The market for interest rate derivatives is considered one of the largest derivatives market in the whole world, with the notional amount being approximately $494 trillion for over the counter interest rate contracts and $342 trillion for interest rate swaps.
There are two categories of interest rate derivative, the exotic interest rate derivative and funding leg derivative. A funding leg normally constitutes a series of fixed or floating coupons plus a fixed spread while an exotic leg consists of a functional dependence on both the past and present underlying indices.
A funding leg is a component of interest rate derivative, where a trader makes use of multiple options contracts or futures contracts in an effort to evade a position or profit from a spread. The funding leg can be broken down into three strategies as follows:
Two-leg strategy: It is also known as long straddle. It consists of a long put and a long call. The combination of the two contracts yields great profit if the essential price of the security asset rises or falls. You will break even if the price goes higher than her net debit, which includes commission fee or it decreases by her net debit but she profits if it moves in either directions. On the other hand, she can lose money but the loss is only limited to the amount she paid.
Three-leg strategy or collar: It contains three legs, a short call, a long put and a long position within the financial asset. The combination of the three contracts amounts to a probability that the essential price go up. However, this is hedged by the long put, which reduces chances of losing. This explains why this combination is normally referred to as a protective put. On the other hand, a short call limits an investor’s potential profit.
Four-leg strategy: This is strategy is a bit complex but has a simple goal, which is to make a good amount of cash on a bet that the underlying price will not have to move very much. The underlying price at the time of expiry will fall between the strike prices of short call and short put.
Exotic interest rate derivatives
This category comprises of interest rate derivatives that have low liquidity and trades occur over the counter. They include cross currency swaption, CMS steepener, Snowball, Inverse floater, Ratchet cap, CMO strip, and Bermudan swaption.
This form of derivative is based on two legs. This includes the funding leg and the exotic coupon leg. The funding leg constitutes a series of fixed or floating coupon payments besides a fixed basis spread. The exotic coupon on the other hand works in view of past and present underlying reference rates such as CMS rate, FX rate and LIBOR.
Examples of Interest Rate Derivative
The most popular examples of interest rate derivative include bond options, floors, swap options and interest rate caps.
Bond options give you the right to buy or sell a particular bond within a certain period of time or a later date at a set price. These options are normally traded over the counter and can also be embedded. An embedded option allows the issuer to redeem or buy back the bond at a predetermined price by specific time or at different times in future. Other bond options include a bond call (callable bonds) and puttable bonds.
Interest rate caps/ floors are designed specifically to protect the holder from exposure to changes in the interest rate movements. It does this blocking such movements. When a purchaser pays for upfront, the benefits of the cap or floors can be recognized over its life.
Interest rate swaps is a derivative that allows holders to carry out exchange of a fixed interest rate on assured notional amount of floating rate of interest rate. It is normally used during conversations of liability from a fixed rate to a floating rate.