Interest Rate Derivatives – Definition | Products | Market Growth

Interest rate derivatives are financial instruments whose value is based on underlying interest rates or interest rate movements. These instruments are widely used by financial institutions, corporations, and investors to manage exposure to fluctuations in interest rates or to speculate on future rate changes. Common types of interest rate derivatives include interest rate swaps, where parties exchange fixed and floating rate interest payments; interest rate futures, which are standardized contracts to buy or sell financial instruments influenced by interest rate expectations; and interest rate options such as caps, floors, and collars that provide the right—but not the obligation—to benefit from favorable interest rate movements.

Table of Contents

1. Derivatives – Definition and Economic Role
2. Products in Derivatives Market
3. Growth Drivers of Derivatives

1. Derivatives – Definition and Economic Role

Derivative is something that is derived from another thing called the underlying. The underlying is independent, and the derivative is dependent on and derived from the underlying. The derivative cannot exist without the underlying. This is the general definition of derivative. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the “underlying”.

However, accounting standards like FAS 133 (in the US), IAS 39 (in the EU) and AS 30 (in India) impose more qualifications for derivatives. For example, IAS 39 and AS 30 require the following three criteria to be satisfied for financial derivatives.

1. Value of derivative is linked to the value of underlying
2. Trade settled on a “future” date
3. On trade date, there should be no full cash outlay FAS 133 requires an additional qualification:
4. Trade must settle (or capable of being settled) on net basis and not on gross basis.

The first requirement implies that the price of derivatives is determined by the price of underlying, and not by the demand-supply for derivative. The underlying is the raw material and derivative is the finished product. If the underlying price goes up (or down), the derivative price will go up (or down) regardless of demand-supply for derivative.

The “future” date in the second requirement means that the settlement of the derivative must be later than that for underlying. For example, if the underlying settles on two business days after trade date (T+2), the derivative on that underlying must settle later than T+2; if the underlying settles in T+5, the derivative on that underlying must settle later than T+5; and so on.

The third requirement provides “leverage” – ability to buy the underlying without fully paying for it immediately or sell it without delivering it immediately.

Derivatives are classified into five asset classes – rate, credit, equity, forex and commodity. In each asset class, there are four generic products – forward, futures, swap and option.

Derivative products initially emerged as hedging devices against fluctuations in commodity prices, and commodity linked derivatives remained the sole form of such products for almost three hundred years. Financial derivatives came into spotlight in the post 1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two thirds of total transactions in derivative products. In recent years, the market for financial derivatives has grown tremendously in terms of variety of instruments available, their complexity and also turnover.

Derivatives are tools to manage price risk. How you manage risk depends on your approach to risk. If you want to take risk , you will trade in derivatives which is called speculation. When you want to avoid risk, you manage it one of the three ways – elimination (called hedging); insurance and minimization (called diversification). The following table summarises the approaches to market risk management.

The following table summarises the approaches to risk management:

Let’s understand derivatives with simple example:

• A wheat farmer and a miller sign a contract to exchange a cash of Rs. 10000 for a 100 Kg. of wheat after 2 months. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called Forward Price and the settlement date is called Expiration Date. Both parties have reduced a future risk – for the wheat farmer, the uncertainty of the price, and for the miller, the availability of wheat at a specific price.
• Still there is risk in the contract, firstly, no wheat will be available or that one party will renege on the contract. Both reduce a risk and acquire a risk when they sign the derivative contract.
• The farmer reduces the risk that the price of wheat will fall below the price specified in the contract and acquires the risk that the price of wheat will rise above the price specified in the contract (thereby losing additional income that he could have earned).
• The miller, on the other hand, acquires the risk that the price of wheat will fall below the price specified in the contract (thereby paying more in the future than he otherwise would have) and reduces the risk that the price of wheat will rise above the price specified in the contract.

1.1 Key Economic Functions of Derivatives

Though the primary economic role of derivatives is Risk Management, derivatives market also serves the following functions:

• Hedging risk exposure – Since the value of the derivatives is linked to the value of the underlying asset, the contracts are primarily used for hedging risks. For example, an investor may purchase a derivative contract whose value moves in the opposite direction to the value of an asset the investor owns. In this way, profits in the derivative contract may offset losses in the underlying asset.
• Price discovery – Derivative market serves as an important source of information about prices. Prices of derivative instruments such as futures and forwards can be used to determine what the market expects future spot prices to be. In most cases, the information is accurate and reliable. Thus, the futures and forwards markets are especially helpful in price discovery mechanism.
• Market efficiency – It is considered that derivatives increase the efficiency of financial markets. By using derivative contracts, one can replicate the payoff of the assets. Therefore, the prices of the underlying asset and the associated derivative tend to be in equilibrium to avoid arbitrage opportunities.
• Access to unavailable assets or markets – Derivatives can help organisations get access to otherwise unavailable assets or markets. By employing interest rate swaps, a company may obtain a more favourable interest rate relative to interest rates available from direct borrowing.
• Price Stability – It has been seen that many countries central banks uses derivatives for stabilising the currency prices. In India, RBI also intervene in forex market through derivatives for INR stability.
• Derivatives, due to their inherent nature, are linked to the underlying markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk.
• Speculation – Financial speculation involves the buying, holding, selling, and short-selling of stocks, bonds, commodities, currencies, real estate, derivatives, or of any other financial instrument, in order to profit from fluctuations in its price. This is not the only use, and probably not the most important use, of financial derivatives. Financial derivatives are considered to be risky. If not used properly, these can lead to financial destruction in an organisation. However, these instruments function as a powerful instrument for knowledgeable traders to expose themselves to calculated and well understood risks in search of a reward, that is, profit.
• Derivatives market helps shift of speculative trades from an unorganised market to organised market. Risk management mechanism and surveillance of activities of various participants in organised space provide stability to the financial system.

Market Participants must understand that derivatives, being leveraged instruments, have risks like counterparty risk (default by counterparty), price risk (loss on position because of price move), leverage risk (magnifying the gain and losses), liquidity risk (inability to exit from a position), legal or regulatory risk (enforceability of contracts), operational risk (fraud, inadequate documentation, improper execution, etc.) and may not be an appropriate avenue for someone of limited resources, trading experience and low risk tolerance. A market participant should therefore carefully consider whether such trading is suitable for him/her based on these parameters. Market participants who trade in derivatives are advised to carefully read the Risk Disclosure Document, given by the broker to his clients at the time of signing agreement.

2. Products in Derivatives Market

As specified earlier, derivatives can be classified into five asset classes – interest rate, credit, equity, forex and commodity. In each asset class, there are four generic products – forward, futures, swap and option. We will examine this product with interest rate as asset class. Interest Rate Derivative (IRD) is a financial derivative contract whose value is derived from one or more interest rates, prices of interest rate instruments, or interest rate indices.

2.1 Forwards

It is a contractual agreement between two parties to buy/sell an underlying asset at a certain future date for a particular price that is pre-decided on the date of contract. Both the contracting parties are committed and are obliged to honour the transaction irrespective of price of the underlying asset at the time of delivery. Since forwards are negotiated between two parties, the terms and conditions of contracts are customised. These are Over-the-Counter (OTC) contracts. Contracts are mainly settled in delivery. However, in certain cases, they are settled in cash on expiration date. Generally, no margin or mark to market is collected for such contracts.

Forward Rate Agreement (FRA) is an interest rate derivative contract that involves exchange of interest payments on a notional principal amount, on a future date, at agreed rates, for a defined forward period. For example, two parties can enter into an agreement to borrow INR 100 Crores after 60 days for a period of 91 days, at say 5% p.a. and settlement is based on 91-day T-Bills yield. This means that the settlement date is after 60 days, on which date the money will be borrowed/lent for a period of 90 days. The party that is borrowing money under the FRA has a long position, and the party that is lending money has a short position in the FRA. FRA contracts are usually cash-settled, that is, the money is not actually lent or borrowed. Instead, the forward rate specified in the FRA is compared with the benchmark rate (in this case 91-day T-Bills yield). If the benchmark rate is greater that the FRA rate, then the long is effectively able to borrow at a below market rate. The long will therefore receive a payment based on the difference between the two rates. Assume that on the settlement date, the actual 91-day T-Bills yield is 5.5%. This means that the long is able to borrow at a rate of 5% under the FRA, which is 0.5% less than the market rate. Total saving for borrower in interest = 100 Crores × 0.5% × 91/365 = Rs. 12.46 lacs. The borrower would save Rs. 12.46 lacs by entering into an FRA. However, we need to make one more adjustment to get the accurate value. The settlement in FRA is on a cash basis, and settlement takes place on a pre-decided date. But the saving above is after the duration of the loan (in the above example after 91 days). So, the present value of the expected savings needs to be calculated to determine the accurate quantum of savings.

2.2 Futures

A futures contract is similar to a forward, except that the deal is made through an organized and regulated exchange rather than being negotiated directly between two parties. Indeed, we may say futures are exchange traded forward contracts. Contracts are mainly settled in cash; however in certain cases they are settle in physically on expiration date. Margins and mark to market are applicable for such contracts. Settlement guarantee is provided by the clearing corporation of the Exchanges.

Interest Rate Futures (IRF) are standardised interest rate derivative contracts traded on a recognised stock exchange to buy or sell a notional security or any other interest-bearing instrument or an index of such instruments or interest rates at a specified future date, at a price determined at the time of the contract. Interest Rate Futures also include money market Futures.

2.3 Options

An Option is a contract that gives the right, but not an obligation, to buy or sell the underlying on or before a stated date and at a stated price. While buyer of option pays the premium and buys the right, writer/seller of option receives the premium with obligation to sell/buy the underlying asset, if the buyer exercises his right. Call Option gives buyer of an option the right to buy the asset and put option gives buyer of an option the right to sell the asset. In case of futures/forwards, it is an obligation on both buyer as well as seller to settle the contract, however in option the buyer of an option has right but not the obligation to buy/sell the underlying asset:

• Interest Rate Option (IRO) is an option contract whose value is based on interest rates or interest rate instruments. IRO traded in OTC as well as Exchange Traded market.
• An Interest Rate Cap is a series of interest rate call options (called caplets) in which the buyer of the option receives a payment at the end of each period when the underlying interest rate is above a rate agreed in advance (strike rate).
• An Interest Rate Floor is a series of interest rate put options in which the buyer of the option receives a payment at the end of each period when the underlying interest rate is below the strike rate.
• An Interest Rate Collar is a derivative contract where a market participant simultaneously purchases an interest rate cap and sells an interest rate floor on the same interest rate for the same maturity and notional principal amount.
• A Reverse Interest Rate Collar is a derivative contract which involves simultaneous purchase of an interest rate floor and sale of an interest rate cap on the same interest rate for the same maturity and notional principal amount.

In subsequent chapters we will learn in detail about Exchange traded interest rate futures and options.

2.4 Swaps

A swap is an agreement made between two parties, to exchange cash flows in the future, according to a prearranged formula. Swaps are, broadly speaking, series of forward contracts. Swaps help market participants manage risk associated with volatile interest rates, currency exchange rates and commodity prices etc. Most swaps involve cash flows based on a notional principal amount such as a loan or bond, although the instrument can be almost anything. One cash flow is generally fixed, while the other is variable and based on a benchmark interest rate, floating currency exchange rate, or index price etc.

Interest rate swap is a derivative contract that involves exchange of a stream of agreed interest payments on a `notional principal’ amount during a specified period. Such contracts generally involve exchange of a `fixed to floating’ or `floating to floating’ rates of interest. On each payment date that occurs during the swap period cash payments based on fixed/floating and floating rates, are made by the parties to one another.

Example

• “A” will pay Overnight MIBOR & receive fixed rate of 3.75%
• “B” will pay fixed rate of 3.75% p.a. & receive Overnight MIBOR
• Tenor – 1 month
• Notional Value – Rs.100 Crores

# Interest calculating using daily compounding

Interest Payable by “A” = Rs. 3158169

Interest Receivable by “A” = Rs. 3287671

(100 Crores × 3.75% × 32/365)

Net Pay-off for “A” = Rs. 129503

Net Pay-off for “B” = (Rs. 129503)

A swaption is an option on swaps. A swaption gives the buyer the right, but not the obligation, to enter into swap. Interest rate swaptions are more popular in the financial market. An Interest Rate Swaption is an option on interest rate swaps. A swaption gives the buyer the right, but not the obligation, to enter into an interest rate swap.

The following table summarises the key feature of four generic types of derivatives.

Different kind of derivatives based on underlying

Additionally “Credit” risk as underlying, Credit Default Swaps (CDS) are also very popular in the financial market. One counterparty in the CDS contract (the “buyer of protection”) makes a regular periodic payment to the other counterparty (the “seller of protection”); in exchange the protection seller agrees to pay the protection buyer any loss in value on the specified reference obligation if a “credit event” (e.g., default) were to occur during the life of the CDS contract.

3. Growth Drivers of Derivatives

Over the last three decades, the derivatives market has seen a phenomenal growth. A large variety of derivative contracts have been launched at exchanges across the world. Some of the factors driving the growth of financial derivatives are:

1. Increased volatility in asset prices in financial markets,
2. Increased integration of national financial markets with the international financial markets,
3. A significant growth of derivative instruments has been driven by technological breakthrough. Advances in this area include the development of high-speed processors, network systems and enhanced method of data entry.,
4. Development of more sophisticated risk management tools, providing a wider choice of risk management strategies, and
5. Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets, leading to higher returns, reduced risk and lower transactions costs as compared to individual financial assets.

3.1 Interest Rate Derivatives

Interest rate derivatives are the most important among all derivatives, as shown in the following tables of notional outstanding amount:

Notional Amount Outstanding (USD Billion) in Exchange Traded Derivatives as of September 2023

Source – Bank for International Settlement

Exchange Traded Daily Average Turnover (USD Billion) for year 2022

Source – Bank for International Settlement