A derivative is a financial instrument that derives its value from an underlying asset or group of assets. This derivative usually comes in the form of a contract between two parties. Any movements in the underlying asset's value cause a fluctuation in the derivative's value as well. Derivatives may have various underlying assets, such as stocks, bonds, commodities, interest rates, etc.
What is an Interest Rate Derivative?
An interest rate derivative is a type of financial derivative that derives its value from movements in an interest rate or several interest rates. Interest rate derivatives are financial instruments most commonly used in hedging or speculation on interest rate fluctuations. Usually, these include financial instruments, such as futures, options, swaps, forwards, etc.
Interest rate derivatives are prevalent among both individual, business, and institutional investors. All these parties use interest rate derivatives in some form to protect against the adverse effects of interest rate fluctuations. However, some investors may also use interest rate derivatives as a diversification tool or to alter their risk profile.
How do Interest Rate Derivatives work?
Interest rate derivatives help investors mitigate the risks associated with various debt instruments. These risks usually involve interest rate risks that come from market interest rate fluctuations. These derivatives also allow investors to speculate on the direction of future interest rate movements. Investors can either make profits from this speculation or use it to mitigate risks.
Interest rate risks are inherent to any debt instrument that accompanies interest payments. These risks come as a result of any fluctuations in the market interest rates. Therefore, investors need to invest in an interest rate risk management process to mitigate these risks. For that, investors can use interest rate derivatives in various forms.
What are the types of Interest Rate Derivatives?
As mentioned, investors can use interest rate derivatives in various forms. Some of the types of interest rate derivatives are as below.
Forward Rate Agreements
Forward rate agreements are a type of interest rate derivate that investors use to protect against interest rate risks. Forward rate agreements allow investors to fixate interest rates in the future with a counterparty. This way, they can benefit from lower interest rates if the market interest rates rise in the future.
Interest Rate Options
Interest rate options are also a common type of interest rate derivatives that investors can use to mitigate interest rate risks. Interest rate options allow investors to speculate on the direction in which market interest rates will move in the future. Using this method, investors can either make profits from the speculation or protect their securities from interest rate risks.
Swaps
Swaps are a type of interest rate derivatives that allow counterparties to exchange their cash flows from debt instruments. There are two prevalent types of swaps that investors can utilize. These include interest rate swaps and credit default swaps. Usually, investors use interest rate swaps to exchange interest payments from floating rate instruments with fixed-rate ones.
Conclusion
Interest rate derivatives are financial instruments that derive their value from underlying interest rate movements. Interest rate derivatives allow investors to protect against the adverse effects caused by interest rate fluctuations. There are various types of interest rate derivatives that are prevalent in the market. These include, but are not limited to, forward rate agreements, interest rate options, and swaps.
Originally Published Here: What is an Interest Rate Derivative?
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