Types of derivatives


Interest-rate swaps

An interest-rate swap is a contract between two parties to exchange interest-payment obligations. Most often, this involves an exchange of fixed-rate for floating-rate obligations. For example, firm A, which obtained a floating-rate bank loan because fixed-rates loans were unattractively priced, may prefer a fixed payment that can be covered by a fixed stream of income, but firm B might prefer to exchange its fixed-rate obligation for a floating rate to benefit from an anticipated fall in interest rates. In a simple swap, firm A might pay $30,000 to exchange its obligation to make payments for two years on a $1m notional amount at 1% above the London Inter-Bank Offer Rate (libor) for firm B’s obligation to pay interest on $1m at a fixed 7% rate. The notional amounts themselves do not change hands, so neither party is responsible for paying off the other’s loan.

The value of an interest-rate swap obviously depends upon the behaviour of market rates. If rates were to decline, the swap position held by firm B would increase in value, as it would be required to make smaller payments over the next two years; and firm A’s fixed-rate position would lose value because the rate is now far above what the market would dictate. However, if rates were to rise, firm A’s side of the swap would be worth more than firm B’s.  Around half the notional value of interest rate swaps is owned by banks, and half by other users. Financial institutions are the main end users, for purposes such as hedging mortgage portfolios and bond holdings.

Currency swaps

Currency swaps involve exchanging streams of interest payments in two different currencies. If interest rates are lower in the euro zone than in the UK, for example, a British company needing sterling might find it cheaper to borrow in euros and then swap into sterling. The value of this position will depend upon what happens to the exchange rate between the two currencies concerned during the life of the derivative. In most cases, the counterparties to a currency swap also agree to exchange their principal, at a predetermined exchange rate, when the derivative matures. The market for currency swaps is much smaller and more diverse than that for interest-rate swaps. The notional value of currency swaps used by financial institutions, for example, is barely 5% of the notional value of those same institutions’ interest-rate swaps. The overall market has grown far more slowly than that for interest-rate swaps. As each swap involves two different currencies, the total value of swaps outstanding is only one-half of the sum of the value of swaps in each currency. The average size of a currency swap exceeds $30m.

Interest-rate options

This category involves a large variety of derivatives with different types of optionality. A cap is an option contract in which the buyer pays a fee to set a maximum interest rate on a floating-rate loan. A floor is the converse, involving a minimum interest rate. A customer can purchase both a cap and a floor to arrange a collar, which effectively allows the interest rate to fluctuate only within a predetermined range. It is also possible to arrange options on caps and floors. A swaption is an option that gives the owner the right to enter into an interest-rate swap, as either the fixed-rate payer or the floating-rate payer, at a predetermined rate. A spread option is based on the difference between two interest rates in the same currency rather than on the absolute level of rates; such an option might be used to protect an investor in long-term bonds, for example, against the risk that the yield curve will steepen and the bonds will lose value relative to short-term bonds. A difference or “diff” option is based on differences in interest rates on comparable instruments in different currencies. Interest-rate options can also be built into fixed-income products, making them respond to interest-rate changes in ways different from normal securities. Inverse floaters (also called reverse floaters) are interest bearing notes whose interest rate is determined by subtracting an index from a fixed rate, giving a formula such as 10% – six-month libor; the investor thus receives less interest (and the value of its position declines) when interest rates rise, in contrast to most floating-rate securities. Multiple-index floaters have interest rates that are based on the difference between two rates, and step-up coupon notes have interest rates that increase if the security has not been called by a certain date.

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