RISK MANAGEMENT

Interest rate
derivatives
Executive Summary

NAME: AKSHAYA AGRAWAL

NO : 14303

ROLL

EXECUTIVE SUMMARY:
A financial instrument based on an underlying financial security whose value is affected by changes
in interest rates. Interest-rate derivatives are hedges used by institutional investors such as banks to
combat the changes in market interest rates. Individual investors are more likely to use these
derivatives as a speculative tool, they hope to profit from their guesses about which direction market
interest rates will move. This case talks about the six major interest rate derivative products: swaps,
forward rate agreements, Eurodollar futures, bond options, caps/floors/collars, and swap options-the
basic interest rate derivative instruments used in the market today. It walks us through both the cash
flows involved and the institutional differences between each of the instruments.
Swap is an instrument used for the exchange of stream of cash flows to reduce risk. The main
advantages of swaps are they reduce transaction costs, maintain informational advantages and
possibility of a long time period hedging whereas the drawback is that it does not provide much
liquidity and are subject to default risks. A forward rate agreement is a forward contract, the purpose
of which is to set an interest rate for a future transaction. They reduce the exposure to negative
interest rates, provide guaranteed interest rates, are flexible and require no principle. Eurodollar
futures are cash settled futures contract on an interest rate for a 3 month loan .They are essentially the
futures equivalent of forward rate agreements. However, because Eurodollar futures are exchange
traded, they offer greater liquidity and lower transaction costs, but cannot be customized like over the
counter FRAs. Since Eurodollar futures are margined, there is virtually no credit risk because any
gains or losses are marked to market. As such, if interest rates move in our favor, we receive cash
compensation that day rather than waiting until expiry. These settlements are done every day. Since
the contract is cash settled, no loan is actually extended even though the contract mentions a notional
principal amount. Bond options are rights to buy fixed income securities at predetermined exercise
price. The main advantages are they limit potential losses without limiting potential gains and do not
tie up much capital and the drawbacks are that they are written for fixed amounts and terms, not
much liquidity, they are subject to basis risk and offer only a partial hedging. A swaption is a right,
but not an obligation, to take a position on a swap at a specific swap rate. It hedges the buyer against
downside risk, as well as letting the buyer take advantage of any upside benefits i.e it gives the buyer
the benefit of the agreed upon rate if it is more favorable than the current market rate, with the
flexibility of being able to enter into the current market swap rate if it is preferable. Cap is a series of
European interest rate call options used to protect against rate moves above a set strike level; Floor a
series of European interest rate put options used to protect against rate moves below a set strike level;
and collar is the simultaneous purchase of an interest rate cap and sale of an interest rate floor on the
same index for the same maturity and notional principal amount.
We might have a good understanding of our financing needs but management of interest rate
exposure may be less clear. So once we have our capital structure in place whether it is a term loan
a revolving credit facility we need to think about managing interest rate exposure over the life of the

loan. The reason for using these interest rate derivatives are that they are cheaper in execution costs
than underlying instrument transactions, quicker for adjusting the portfolio positions and more liquid
than underlying instruments.