** **An
**interest rate derivative** is a derivative where the underlying asset is the right
to pay or receive a (usually notional) amount of money at a
given interest rate.

The interest
rate derivatives market is the largest derivatives market in
the world. Market observers estimate that $60 trillion dollars
by notional value of interest rate derivatives contract had
been exchanged by May 2004. Measuring the size of the market
is difficult because trading in the interest rate derivative
market is largely done over-the-counter. 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 options and 10% for stock options.

## Types

These are
the basic building blocks for most interest rate derivatives
and can be described as vanilla (simple, basic derivative structures,
usually most liquid) products:

The next
intermediate level is a quasi-vanilla class of (fairly liquid)
derivatives, examples of which are:

- Range
accrual Swaps/Notes/Bonds
- In-arrears
Swap
- Constant
maturity swap (CMS) or constant treasury swap (CTS) derivatives
(swaps, caps, floors)
- Interest rate swap based upon two floating
interest rates

Building
off of these structures are the exotic interest rate derivatives
(least liquid, traded over the counter), such as:

- Power
reverse dual currency note (PRDC or Turbo)
- Target
redemption note (TARN)
- CMS steepener
- Snowball
- Inverse
floater
- Strips
of Collateralized mortgage obligation
- Ratchet
caps and floors
- Bermudan
swaptions
- Cross
currency swaptions

Most of
the exotic interest rate derivatives can be classified as to
have two payment legs: funding leg and exotic coupon leg. A
funding leg usually consists of series of fixed coupons or floating
coupons (LIBOR) plus fixed spread. An exotic coupon leg typically
consists of a functional dependence on the past and current
underlying indices (LIBOR, CMS rate, FX rate) and sometimes
on its own past levels, as in Snowballs and TARNs. The payer
of the exotic coupon leg usually has a right to cancel the deal
on any of the coupon payment dates, resulting in the so-called
Bermudan exercise feature. There may also be some range-accrual
and knock-out features inherent in the exotic coupon definition.

These structures
are popular for investors with customized cashflow needs or
specific views on the interest rate movements (such as volatility
movements or simple directional movements).

Modeling
of interest rate derivatives (see Mathematical Finance) is usually
done on a time-dependent multi-dimensional tree built for the
underlying risk drivers, examples of which are domestic/foreign
short rates and Forex rate.

**Example
of Interest Rate Derivatives**

**Interest
Rate Cap**

An interest rate cap is designed to hedge a company™s
maximum exposure to upward interest rate movements. It establishes
a maximum total dollar interest amount the hedger will pay out
over the life of the cap. The interest rate cap is actually
a series of individual interest rate caplets, each being an
individual option on the underlying interest rate index. The
interest rate cap is paid for upfront, and then the purchaser
realizes the benefit of the cap over the life of the instrument.

**Range
Accrual Note**

Suppose
a manager wished to take a view that volatility of interest
rates will be low. He or she may gain extra yield over a regular
bond by buying a range accrual note instead. This note pays
interest only if the floating interest rate (i.e.London Interbank
Offered Rate) stay within a pre-determined band. This note effectively
contains an embedded option which is, in this case, the buyer
of the note has sold to the issuer. This option adds to yield
of the note. In this way, if volatility remains low, the bond
yields more than a standard bond.

**Bermudan
Swaption**

Suppose
a fixed-coupon callable bond was brought to the market by a
company. The issuer however, entered into an interest rate swap
to convert the fixed coupon payments to floating payments (based
on LIBOR maybe). Since it is callable however, the issuer may
redeem the bond back from investors at certain
dates during the life of the bond. If called, this would leave
the issuer still with the interest rate swap
however. Therefore, the issuer also enters into Bermudan swaption
when the bond is brought to market with exercise dates equal
to callable dates for the bond. If the
bond is called, the swaption is exercised, effectively canceling
the swap leaving no more interest rate exposure for the issuer.

**References**

- Hull,
John C. (2005)
*Options, Futures and Other Derivatives*,
Sixth Edition. Prentice Hall. ISBN 0131499084
- Marhsall,
John F (2000).
*Dictionary of Financial Engineering*.
Wiley. ISBN 0471242918

External
links