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Interest Rate Derivatives

Article by
Dheeraj Vaidya, CFA, FRM

Interest Rate Derivatives Definition

Interest Rate Derivatives are the derivatives whose underlying is based on a single
interest rate or a group of interest rates; for example, interest rate swap, interest rate
vanilla swap, floating interest rate swap, and credit default swap.

You should know what derivative security is if you are reading this material. It is a
security that derives its value from an underlying asset. The underlying asset could be
anything ranging from a company’s stock, a bond, metals, commodities, and other
asset classes. If the underlying is an interest rate, the derivative security becomes an
interest rate derivative. The underlying interest rates depend on the contract, which is
agreed to by the counterparties and can range from LIBOR, domestic interbank
offered rates, Fed Funds Rate, etc.

Table of contents

• Interest Rate Derivatives Definition

◦ What are Swaps?

◦ Interest Rate Options (Interest Rate Derivatives)

◦ Forward Rate Agreements (FRAs)

◦ Conclusion

◦ Recommended Articles

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What are Swaps? 

This is an important and exciting area under fixed income derivatives. It is an example
of a structured transaction to hedge risks in a fixed income investment.

A swap is a contract between counterparties to exchange a series of intermediate cash

flows arising throughout the tenor/life of the trade. Almost every swap contract comes
under an interest rate swap. Most of them are variants of interest rate swaps.

Interest Rate Swaps

So what is an interest rate swap (IRS)?

An IRS is a swap contract to exchange a series of intermediate cash flows based on

interest rates on a notional amount throughout the swap’s tenor.

In general, they come in the form of exchanging cash flows from a fixed interest rate
for cash flows from a floating interest rate over the swap’s tenor. This type of trade is
also known as a set for a floating swap where the leg of the swap pays/receives a fixed
rate, and the other leg, a floating rate. It is also called a plain vanilla IRS.

Here’s a simple example to illustrate a fixed for the floating swap. We all know that a
bank takes deposits and makes loans. Let’s assume that for the deposits Bank A takes,
they pay a fixed interest rate of 5%. For the loans they make, let’s presume they charge
a floating rate of interest, which is the LIBOR (say 3%) plus a spread (3%) over it to
account for the borrower’s riskiness. The spread is fixed, but the LIBOR keeps changing.
If, for example, LIBOR falls to 1% or below by year-end, banks will be paying a constant
5% on deposits but charging lesser on their loans. To safeguard against this risk of
making a lower interest margin ultimately due to rates falling, they enter into an IRS
with another Bank B. Take some time to think about how the IRS would be structured.

Done? Here it is – Bank A currently pays fixed and receives floating on its deposits and
loans, respectively. They will enter an IRS with Bank B to pay to float and receive fixed
for a certain period, say three years. Effectively, the structure of the transaction will
look like this:

The Swap Rate here is only indicative – a no-arbitrage rate has been calculated.

As mentioned earlier, the swap payments/cash flows are based on a notional amount.
Bank A’s exposure to interest rates is benefited by paying floating on the swap. If rates
go up above 5%, Bank A still benefits since it pays a lower rate on its deposits, and the
higher rate will be passed on through the loans it makes, which finance the swap’s
floating leg. Why does Bank B act as a counterparty to Bank A? Simply because they

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would have the opposite exposure where they pay floating on their deposits and

receive fixed on their loans.

I hope you got the structure of a swap. Counterparties agree to swap since they either
have opposite views or exposures to the underlying.

Currency Swap
These are also called Cross Currency Swaps or Cross Currency Interest Rate Swaps. A
good way to refer to it is “Xccy IRS.” As you would guess, this is a variant of an IRS, the
difference being two different currencies involved.

A typical transaction would be Bank A (Japanese bank) borrowing say $10m (Notional
amount) @ 5% p.a. and lending ¥100m (Notional amount) @ 3% p.a. to Bank B (US
bank) for five years as part of an Xccy swap. Bank A pays B $500,000 to Bank B, while
Bank B pays ¥3m to Bank A as swap payments every year throughout the life of the
swap. This is a fixed-for-fixed swap, as you can notice.

A fixed for fixed Xccy IRS is simple. A fixed for floating Xccy IRS works similarly to an
equivalent IRS except for two currency legs. A fixed floating IRS will have the
intermediate cash flows netted against each other depending on a gain or loss. For
example, Bank A may borrow $10m at LIBOR + 2% instead of 5%. If Bank A’s interest
payment at the end of the year is $300,000 and Bank B’s is $500,000 after converting
to USD, then Bank B will pay the difference of $200,000 to A. Similar would be the case
when A has to pay B the difference.

A floating for floating Xccy IRS (Basis Swap) and normal IRS is also part of the
structuring game. Though it is easy, we can end this discussion here rather than get
deeper and deeper.

Difference between an Xccy swap and an IRS

An Xccy swap and an IRS differ apart from the currency legs. The Notional amounts on
which the interest payments/cash flows are made are exchanged in the beginning and
end in an Xccy swap. The same doesn’t hold for an IRS. In the earlier example, the
notional principal of $10m and ¥100m are exchanged at the beginning and end.
Therefore an Xccy swap eliminates currency risk or exchange rate risk of the notional
principal amounts.

Other types of Swaps

There are other types of swap derived from interest rates like an Equity swap or a Total
Return Swap (TRS), where the swap rate is paid on one leg, and the other leg pays
equity/equity index-related payments like the
dividends and capital gains differences; Overnight Indexed Swap (OIS) which is a
fixed for a floating swap where the floating rate is based on a geometric average of
floating rates on an overnight index say LIBOR or Fed Funds.

 Uses of Swaps
Just like any other derivative contract, swaps are used as a tool to hedge risk. The

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examples mentioned till now emphasized swaps as a tool to hedge risk. Meanwhile,

they can also speculate on interest rates where a counterparty may not have an initial
exposure. Thirdly, they can be used to make arbitrage gains if the swap rates are
slightly mispriced. Here, the mispricing difference is quickly noticed whereby multiple
entities would like to make a riskless profit, ultimately making this demand and supply
lead to an equilibrium rate that cannot be arbitraged away.

Interest Rate Options (Interest Rate Derivatives)

Given that we’re on the topic of swaps, it would be right to introduce this type of
interest rate derivative.

Swaption
This is an option on swap – a double derivative. It isn’t difficult, though. An option
gives the buyer of the option the right but not the obligation to buy or sell the
underlying at a predetermined strike price on a future date (at expiration in the case of
European Options; before or at expiration in the case of American Options). You can
google up for more options.

In the case of a Swaption, the strike price is replaced by a strike rate, an interest rate
based on which the buyer can choose to exercise the option, and the underlying is a
swap. More theory will only complicate things, so here’s a simple example.

ABC buys a 3-year Swaption where they pay fixed and receive floating (they buy a
payer Swaption) at a strike rate of 2% exercisable at the end of one year. If the
reference rate is greater than 2% at expiration, ABC will exercise the option following
which the swap takes effect for three years. The option will not be exercised if the
reference rate is less than 2%.

Caps and Floors

As the terms should indicate, a Cap caps one’s risk, and Floor floors one’s risk. Caps
and Floors are options on interest rates, i.e., the underlying is an interest rate, and the
strike rate is the rate at which the buyer exercises the option. They are generally issued
with Floating Rate Bonds/Notes (FRNs).

Caps consist of a series of ‘Caplets’ and Floors of ‘Floorlets.’ Caplets and Floorlets are
essentially caps and floors but with short time frames. A one-year Cap may consist of
four Caplets with a tenor/expiration of 3 months each.

Generally, a Cap transaction goes like this: ABC Corporation issues a floating rate bond
at LIBOR+2%, where LIBOR may be at 3%. The risk for ABC is if interest rates or LIBOR
rise quickly, say in a year, they have to pay higher rates. So, along with the bond, they
buy a Cap from a bank at a strike of 3.5% so that if LIBOR goes above 3.5%, ABC
exercises the Cap. Exercising makes ABC pay only 3.5%, and they make the profit,
which is the difference between LIBOR or the reference rate and 3.5% over that period. 
The profit helps repay the increase in LIBOR; thus, ABC is effectively capped in his
payments.

In the worst-case scenario, ABC ends up paying only 5.5%. If ‘minus (-)’ indicates

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outflows and ‘plus (+)’ inflows, here is how it would look for ABC Corp if the payments

were agreed on an annual basis:

FRN payments:  ‒ (LIBOR + 2%)

Cap related payment: +LIBOR – 3.5%

Combining both would give:  – 3.5% – 2% = –5.5%, thus limiting the borrower’s
exposure to interest rate changes.

A floor similarly would be combined with an FRN but by lenders. So ABC Corp’s bond
lender would buy a floor to limit their exposure to interest rate changes. This time, you
should be able to structure the transaction without my giving you an example.

There are variants of caps and floors, one of them being ‘interest rate collars,’ which
are a combination of buying a cap and selling a floor but let’s not get into that.

Learn more about Options and Trading Strategies

Forward Rate Agreements (FRAs)

These are forward contracts on interest rates between counterparties. FRAs are
contracted to borrow or lend money at a predetermined rate on a notional principal at
a future time.

ABC may enter into an FRA to borrow @ 5% on a notional amount for three months,
starting after six months (a 6X9 FRA – an FRA expiring after six months to borrow
money for three months). This helps ABC in the event of 3-month interest rates going
up at the end of 6 months from today.

ABC could also enter into an FRA to lend @ 5% on a notional amount for three
months, starting after six months (a 6X9 FRA – an FRA expiring after six months to
borrow money for three months). This helps ABC in the event of 3-month interest rates
going down at the end of 6 months from today.

Conclusion
The examples given might be overly simplistic, practically Interest Rate Derivatives. The
concepts are quite simple, but we have not gone into the nitty-gritty of the workings.
The calculations are a bit complex, but it is fair if we understand the concepts for now.
Sometimes being the jack of all might be worth it – the world lacks good generalists.
Go over the concepts explained, try getting the hang of it, and answer the open-ended
questions under each concept because it ultimately helps strengthen your
understanding and makes you think. As regards practical examples, there are loads of
examples on swaps, lesser-known ones on interest rate options, and FRAs, although
they are done very regularly. Google those once you get the hang of these concepts to
understand them better.

Recommended Articles
• Top Derivatives Careers

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• Derivatives in Finance

• What is C Corporation?

Comments
• Bond Pricing

1. Moyo says

The greatest teacher ever.

Reply

2. Amey Ambardekar says

Thank you, this is the simplest explanation of IRD I have read till now.

Reply

◦ Dheeraj Vaidya says

Thanks for your kind words!

Reply

3. Mac Ginley says

I really enjoy reading your blogs because you come up with great work which is very
useful and helpful to readers.

Reply

◦ Dheeraj Vaidya says

thanks Mac!

Reply

4. Firmin Poly says

Thanks for explaining interest rate derivatives in clear way with examples.. this has
helped me a lot to understand about the derivatives. i had a small question can you
explain me What exactly are Swaps in Finance.

Reply

◦ Dheeraj Vaidya says

my pleasure to hear that this has helped u! Thanks and in finance Swaps are nothing
but the exchange of cash flow. If you want to know more about Swaps In Finance then
you can read this article – Swaps in Finance in which I have explained nuts and bolts
of swaps.

Reply
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