Interest rate futures options
The purchase of an interest rate futures option gives the purchaser the right, not the obligation, to sell or buy the underlying interest rate future by a certain date at a certain price. A "short position" is created by the sale of an option or other off-balance sheet instrument where the seller does not initially own the item being sold. The selling/writing of an interest rate futures option where the seller does not initially own the item being sold is an "unhedged" or "naked" transaction that represents a theoretically unlimited liability for the seller.
Interest rate swaps
An interest rate swap is an individually negotiated agreement between two counterparties, usually commercial banks or their wholly-owned special purpose subsidiaries, acting for their corporate clients, to exchange the interest payments on specific debt obligations with identical principal amounts and maturity dates. Interest rate swaps frequently involve the exchange of streams of fixed rate interest payments owed by one borrower for a stream of floating rate interest payments owed by the other.
LIBOR (London Inter-Bank Offered Rate)
The LIBOR is the primary fixed income index reference rates used in the Euromarkets Most international floating rates are quoted as LIBOR plus or minus a spread.
Swaps
A swap is an agreement to exchange a stream of periodic payments with a counterpart. Swaps are available within and between all active financial markets. Traditional interest rate swaps involve the trading of interest rate exposure between two or more parties so that each participant may be able to rebalance its portfolio with less risk. Fixed interest rate exposure and variable interest rate exposure are normally exchanged.
Swaptions
Interest rate caps
The buyer of an interest rate cap is protected by the seller of the cap from all interest rate payments that it would otherwise have to make if the interest rate were to rise above the level specified in the contract, thus creating a "cap" on its interest payment obligation (an upward hedge for the buyer). The seller of a cap is obliged to make all interest payments owing in excess of the cap rate.
Interest rate floors
The buyer of an interest rate floor receives payments from the seller if the interest rate falls below the level specified in the contract, thereby creating a "floor" below which interest rate receipts cannot fall (a downward hedge for the buyer).
Interest rate collar
An interest rate collar is a combination of an interest rate cap and an interest rate floor.
Interest rate futures
Interest rate futures generally are futures contracts on (i) certain specified three month interest rates for a specified currency, such as the U.S. Dollar or (ii) debt instruments issued by a government or government agency, such as the EUR Bund Future-contract which is a basket of EUR-Bundesanleihen with a minimum term to maturity of 8½ -10 years. These futures instruments are publicly quoted, generally in maturities of three months, in nearly all of the key international currencies on a variety of national futures exchanges, including Chicago ("CBOT"), Tokyo (“Tiffe”), London ("LIFFE"), Frankfurt ("EUREX"), Paris ("MATIF"), Singapore ("SIMEX"). Generally, such instruments mature in March, June, September and December of each year. Interest rate futures exhibit a relatively high degree of volatility, based not only on their inherent characteristics but also on the high degree of gearing or leverage (up to 50:1) that may be utilised: the margin (cash) which must be provided on initiation of the transaction may be as little as 2% of the nominal value of the futures contract.
Basis Swap
With a basis swap, each party pays a floating rate of interest, and each is tied to different floating rates. The basis swap sets a spread between two indices for the life of the transaction. Basis swaps are used by banks to hedge the mismatch between the index of their assets and the index of their liabilities, and by swap dealers to create structures for companies to hedge indices other than Libor..
Constant Maturity Swap (CMS)
A CMS is a variation of the fixed rate-for-floating rate interest rate swap. The rate on one side of the constant maturity swap is either fixed or reset periodically at or relative to LIBOR (or another floating reference index rate). The constant maturity side, which gives the swap its name, is reset each period relative to a regularly available fixed maturity market rate. This constant maturity rate is the yield on an instrument with a longer life than the length of the reset period, so the parties to a constant maturity swap have exposure to changes in a longer- term market rate
Cross-currency interest rate swaps
A cross-currency interest rate swap has the features of an interest rate swap while giving each counterparty access to a different foreign currency. Currency principal amounts are exchanged at the outset and re-exchanged at maturity at the same exchange rates, thereby eliminating exchange risk on the principal amounts, while retaining the interest rate exposure and currency exposure on the interest flows and on the net result of any transaction that has been closed out prior to maturity.
Forward rate agreements
A forward rate agreement (“FRA”) is an agreement whereby the seller guarantees the buyer a specific rate of interest for a specific period of time commencing on a specified date in the future. A FRA is frequently used to hedge the floating rate risk in a swap transaction. FRAs are conceptually similar to interest rate futures, offering advantages of precise tailoring to specific transactions such as swaps, but having the disadvantages that they do not trade on an exchange, are not marginable and (as with a swap) are susceptible to counterparty credit risk.
