What are Interest Rate Derivatives?

Interest rate derivative products refer to financial derivative products based on interest rates or interest rate carriers.

Interest rate derivatives

Right!

Interest rate derivative products refer to financial derivative products based on interest rates or interest rate carriers.

Chinese name

Interest rate derivatives

Definition

Interest rate-based financial derivatives

Time

Since the 1970s

Main classification

Forward rate agreement

Since the 1970s, the uncertainty of interest rates has gradually increased, and interest rates have fluctuated more and more. Lenders have adopted floating interest rates. By the 1980s, floating interest rates had been widely used in the field of lending, allowing lenders to better control their exposure to interest rate risk, but at the same time, interest rate risk was passed on to borrowers. As a result, financial products that can effectively control interest rate risk began to emerge and were welcomed in the market. Interest rate futures are the earliest financial products introduced to help companies control interest rate risk. Later, many interest rate derivatives such as forward interest rate contracts and interest rate options have been applied to interest rate risk management.

Development and Status of Interest Rate Derivatives

Interest rate futures contracts based on US dollars were first introduced in CBOT and CME. By the 1980s, futures trading had taken the lead in interest rate risk management products. Interest rate swaps first appeared in 1982, and forward rate contracts appeared in early 1983 ( FRAs) and options were soon introduced into interest rate products. Subsequently, futures-based options contract trading was introduced at CBOT and CME. In 1983, banks introduced interest rate options in the form of over-the-counter (OTC), including the cap, the floor, and the collar. These options are actually a composite of multiple interest rate cap units.

With the intensification of interest rate fluctuations in recent years, interest rate risk has gradually attracted the attention of financial institutions such as banks. In order to avoid interest rate risk, interest rate derivatives have been rapidly developed. The nominal principal has also grown from 63 trillion US dollars in 2001 to 2007. It was 382.3 trillion U.S. dollars in 2007, a six-fold increase in seven years (see Figure 1 for details). The interest rate derivative market is the largest derivative market in the global derivatives market. According to data released by the International Swap and Derivatives Association (ISDA), the total nominal principal of the global derivative market in 2007 was 454.5 trillion US dollars, and Interest rate derivative products (mainly including interest rate swaps, interest rate options, and cross currency interest rate swaps) were US $ 382.3 trillion, accounting for 84.11%. Although this ratio was down from 98.5% in 2001, it can be seen that In the derivatives market, the proportion of interest rate derivatives is still the largest (see Figure 2 for details).

Source: International Swaps and Derivatives Association (ISDA)

Source: International Swaps and Derivatives Association (ISDA)

Major international interest rate derivatives

Generally speaking, the main international interest rate derivatives include the following:

(1) Forward Rate Agreement

A forward interest rate agreement is a type of forward contract in which buyers and sellers (between a customer and a bank or two interbanks) agree on an agreed interest rate for a certain period starting at a certain time in the future (referring to the date on which interest begins) and stipulates what interest rate to use In order to refer to the interest rate, on the date of the future interest calculation, the parties shall pay the discounted amount of the difference between the agreed interest rate and the reference interest rate to the other party according to the stipulated agreed interest rate, term and principal amount.

Under this kind of agreement, the two parties to the transaction agree to borrow a fixed interest rate, a fixed amount, and a nominal principal expressed in specific currencies within a specific period from a certain future date. The buyer of a forward interest rate agreement is a nominal borrower. If the market interest rate rises, he pays interest at the rate determined on the agreement to avoid interest rate risk. However, if the market interest rate falls, he still has to pay the interest at the agreed interest rate. Will suffer. The seller of a forward rate agreement is a nominal lender. He collects interest at the rate determined by the agreement. Obviously, if the market interest rate falls, he will benefit; if the market interest rate rises, he will be damaged.

(II) Interest Rate Futures

Interest rate futures refer to futures contracts with bond securities as the subject matter, which can avoid the risk of changes in securities prices caused by fluctuations in bank interest rates.

Interest rate futures contracts were first introduced by the Chicago Futures Exchange in October 1975. Since then, interest rate futures trading has developed rapidly. Although the generation of interest rate futures is more than three years later than that of foreign exchange futures, its development rate is much faster than that of foreign exchange futures, and its application scope is also much wider than that of foreign exchange futures. At present, in countries and regions where futures trading is more developed, interest rate futures have already surpassed agricultural product futures and become the category with the largest trading volume. In the United States, the volume of interest rate futures has even accounted for more than half of the total futures trading volume.

On August 22, 1977, the US Treasury futures contract was listed on the Chicago Futures Exchange. This contract has achieved unprecedented success and has become the world's largest trading volume. In December 1981, the international currency market launched a three-month Eurodollar time deposit futures contract. This variety has developed rapidly, and its trading volume has now surpassed short-term Treasury futures contracts, becoming one of the most actively traded short-term interest rate futures.

There are many types of interest rate futures, and there are many classification methods. Generally, according to the term of the contract, interest rate futures can be divided into two categories: short-term interest rate futures and long-term interest rate futures.

(3) Interest Rate Swap

Interest rate swap refers to the exchange of fixed interest rate and floating interest rate for two funds with the same currency, the same debt amount (the same principal), and the same term. This exchange is between the two parties. For example, if Party A exchanges a fixed interest rate for Party B's floating interest rate, Party B exchanges a floating interest rate for Party A's fixed exchange rate. The purpose of the swap is to reduce the cost of capital and interest rate risk. Interest rate swaps and currency swaps were both developed in 1982. They are a new financial technology suitable for bank credit and bond financing, and they are also a new type of risk-avoiding financial technique. They have been widely adopted internationally. .

Because interest rate swaps do not involve principal, the two parties only swap interest rates, and the risk is limited to the portion of interest payable, so the risk is relatively small. In addition, interest rate swaps have little effect on the financial statements of both parties. Both parties realized their wishes through swaps, and at the same time reduced funding costs, but interest rate swaps do not have standardized contracts like futures trading. Both parties face greater risk of default, and sometimes they may not find swaps. The other side.

(4) Bond Options

Bond options refer to the right of both parties to the transaction to stipulate in the contract in advance to buy or sell a certain amount of a certain type of bond at a pre-agreed date (or any time before the expiration date).

(5) Interest Rate Option

Interest rate options are a right to change interest rates. The buyer can obtain this right after paying a certain amount of option fee: on the expiration date, borrow or lend a certain amount of currency at a predetermined interest rate for a certain period of time. In this way, when the market interest rate changes in an adverse direction, the buyer can fix its interest rate level; when the market interest rate changes in a favorable direction, the buyer can obtain the benefits of interest rate changes. The seller of an interest rate option collects the option premium from the buyer, and assumes corresponding responsibilities.

Interest rate options are an effective tool to avoid short-term interest rate risk. By buying an interest rate option, the borrower can be protected when the interest rate level changes in an adverse direction, and benefit when the interest rate level changes in a favorable direction. There are several common interest rate options, and the main ones are the upper limit of interest rate, the lower limit of interest rate, and the lower limit of interest rate.

In addition to the above-mentioned major interest rate derivatives, interest rate derivatives are still being introduced, such as interest rate swap options.