Interest rate derivatives

Abstract

Investors in fixed income securities (e.g., floating rate notes) are exposed to changes in interest rates and, hence, the value of the portfolio. Such investors would want to lock in their interest rate risk. This chapter provides an overview of interest rate derivatives like swaps, caps, floors, collars, and swaptions that are commonly used by investors to manage interest rate risk. This chapter has the following objectives: • Provide an overview of interest rate risk management instruments like swaps and caps • Discuss the valuation of these instruments • Introduce the Black's model for valuation of interest rate options like caps • Introduce the use of standard spreadsheet-based calculators in estimating the cap or the floor premium The financial environment is a lot more volatile today than it was a decade back. The volatility in interest rates, exchange rates, and commodity prices give rise to an increased risk exposure. In this chapter currency and interest rate swaps, caps, floors, collars, and swaptions used to manage currency and interest rate exposure are discussed. A swap is an agreement to a future exchange of one stream of cash flows for another. Two common types of swaps are: currency swaps in which one currency is exchanged for another at prespecified terms on one or more prespecified future dates, and interest rate swaps in which one type of interest rate (e.g., fixed rate) is exchanged for another (e.g., floating rate). Swaps are commonly used by companies and financial institutions to hedge risk or to speculate to make a profit. A swap is a privately negotiated agreement between two parties in which both parties are obligated to exchange specified cash flows at periodic intervals for a fixed period of time. A party that intends to swap need not search for a counter party with matching needs. To make our life simple, there are swap dealers who take the other side of the transaction. Swap dealers make a profit by charging a fee or by the difference in bidask spread. © 2009 Springer-Verlag Berlin Heidelberg.