Understanding Interest Rate Derivatives: Types, Uses, and Examples

What Is an Interest Rate Derivative?

An interest rate derivative is a financial instrument whose value is linked to an interest rate or rates. These may include futures, options, or swaps contracts.

Interest rate derivatives are often used as hedges by institutional investors, banks, companies, and individual traders to protect themselves against changes in market interest rates, but they can also be used to adjust the holder's risk profile or to speculate on rate moves. These instruments can vary in complexity, depending on the strategic needs of the investor.

How Interest Rate Derivatives Work

People mainly use interest rate derivatives to hedge against interest rate risk or to speculate on future interest rates. Interest rate risk is the chance that interest rate changes will alter the value of loans or bonds. Interest rate risk management has become very important, and assorted instruments have been developed to deal with interest rate risk.

Interest rate derivatives vary in complexity and can lower or raise interest rate exposure. Among the most common types of interest rate derivatives are interest rate swaps, caps, floors and interest rate collars—which create both a cap and a floor.

Also popular are interest rate futures. Here the futures contract exists between a buyer and seller agreeing to the future delivery of any interest-bearing asset, such as a bond. The interest rate future allows the buyer and seller to lock in the price of the interest-bearing asset for a future date. Forwards on interest rate operate similarly to futures, but are not exchange-traded and may be customized between counterparties.

Mastering Interest Rate Swaps

A plain vanilla interest rate swap is the most basic and common type of interest rate derivative. There are two parties to a swap: party one receives a stream of interest payments based on a floating interest rate and pays a stream of interest payments based on a fixed rate. Party two receives a stream of fixed interest rate payments and pays a stream of floating rate payments. Both payment streams are based on the same notional principal, and the interest payments are netted. Through this exchange of cash flows, the two parties aim to reduce uncertainty and the threat of loss from changes in market interest rates.

A swap can also be used to increase an individual or institution's risk profile, if they choose to receive the fixed rate and pay floating. This strategy is most common with companies that have a credit rating that allows them to issue bonds at a low fixed rate but prefer to swap to a floating rate to take advantage of market movements.

Exploring Interest Rate Caps and Floors

A company with a floating rate loan seeking protection without switching to a fixed rate can buy an interest rate cap. The cap is set at the top rate that the borrower wishes to pay; if the market moves above that level, the owner of the cap receives periodic payments based on the difference between the cap and the market rate. The premium, which is the cost of the cap, is based on how high the protection level is above the then-current market; the interest rate futures curve; and the maturity of the cap; longer periods cost more, as there is a higher chance that it will be in the money.

A company receiving a stream of floating rate payments can buy a floor to protect against declining rates. Like a cap, the price depends on the protection level and maturity. Selling, rather than buying, the cap or floor increases rate risk.

Diverse Interest Rate Instruments Explained

Less common interest rate derivatives include eurostrips, which are a strip of futures on the eurocurrency deposit market; swaptions, which give the holder the right but not the obligation to enter into a swap if a given rate level is reached; and interest rate call options, which give the holder the right to receive a stream of payments based on a floating rate and then make payments based on a fixed rate. A forward rate agreement (FRA) is an over-the-counter contract that fixes the rate of interest to be paid on an agreed upon date in the future to exchange an interest rate commitment on a notional amount. The notional amount is not exchanged, but rather a cash amount based on the rate differentials and the notional value of the contract.