Interest-rate derivatives
Also written Interest-rate derivative · Interest Rate Derivative
Contracts that let borrowers and investors hedge adverse interest-rate movements — interest-rate futures, interest-rate swaps, interest-rate options (caps and floors) and forward rate agreements.
In plain language
Anyone who borrows or lends at a rate that is not yet fixed is exposed to interest rates moving the wrong way. A company with a floating-rate loan fears a rise. A treasurer expecting cash next month fears a fall before he can invest it.
Interest-rate derivatives are contracts whose value moves with interest rates, so that a loss on the underlying borrowing or investment is offset by a gain on the contract. The workbook describes them as contracts that enable investors or borrowers to hedge against the risk of adverse interest-rate movement.
It lists four types: interest-rate futures, interest-rate swaps, interest-rate options and forward rate agreements. Each solves the same problem in a different way.
How it works
| Type | Mechanism in the workbook |
|---|---|
| Interest-rate futures | Underlying is a debt security — T-bills, commercial paper or government securities. Used to lock in a yield or borrowing rate |
| Interest-rate swaps | Two or more parties exchange series of cash flows in the same currency over an agreed period; principals are not exchanged |
| Interest-rate options | Caps and floors; spreads and combinations are also possible |
| Forward rate agreements | OTC contract locking in a rate for a future period on a notional principal, settled in cash |
Futures, both directions. A corporate treasurer who fears a fall in rates before surplus funds arrive locks in today's higher yield by buying an interest-rate futures contract. A banker who fears a rise in rates before raising funds locks in today's lower rate by selling one.
Swaps. Two borrowers hold opposite views — A expects rates to fall, B expects them to rise. On the basis of comparative advantage, it may suit A to borrow fixed and B to borrow floating, and then swap.
Options. A cap is bought to limit the rate on floating-rate borrowings to a ceiling if the benchmark rises. A floor is bought to earn a minimum return on floating-rate investments if the benchmark falls.
Contrast with currency swaps, which the workbook describes just before: there, borrowing in different currencies is exchanged and the principals are re-exchanged at maturity. In an interest-rate swap they are not exchanged at all.
A worked example
Illustrative figures, one per instrument.
Swap. A company has a Rs 50 crore floating-rate loan and expects rates to rise. It enters a swap to pay fixed 7.20% and receive floating, settled half-yearly on the Rs 50 crore notional.
Half-year 1: floating 6.80% → company pays net (7.20 − 6.80)% × 50 cr × 0.5 = Rs 10 lakh
Half-year 2: floating 7.60% → company receives (7.60 − 7.20)% × 50 cr × 0.5 = Rs 10 lakh
Its loan interest moves with the floating rate; the swap offsets it, leaving an effective 7.20 percent. The Rs 50 crore is never exchanged.
Cap. A company with a Rs 20 crore floating-rate borrowing buys an 8% cap. The benchmark rises to 8.50% for a half-year:
Cap payout = (8.50% − 8.00%) × Rs 20 crore × 0.5 = Rs 5 lakh
(Ignoring the premium paid for the cap.) Its effective rate for the period is held at 8 percent.
Futures. A treasurer expecting Rs 200 crore of surplus funds next month fears a fall in yields. He buys interest-rate futures now; if yields fall, the gain on the contract makes up the lower yield he gets on investing the cash.
Why NISM asks about it
Chapter 1.4 (Financial Securities) describes interest-rate derivatives immediately after currency derivatives and swaps. Questions test which party buys or sells futures (the treasurer fearing a fall buys; the banker fearing a rise sells), cap versus floor, and whether principals are exchanged in an interest-rate swap (no) versus a currency swap (re-exchanged at maturity).
Common exam traps
- Fear of falling rates → buy futures; fear of rising rates → sell futures. The workbook's two examples are built to test exactly this.
- Caps protect floating-rate borrowers; floors protect floating-rate investors.
- Interest-rate swap principals are not exchanged; currency swap principals are re-exchanged at maturity.
- Swaps are in the same currency. Different currencies make it a currency swap.
- Interest-rate futures have a debt security as the underlying — the workbook's examples are T-bills, commercial paper and government securities.
- FRAs are OTC; futures are standardised exchange-traded contracts.
Where this is taught
Free preparation for NISM Series III-ARelated terms
- HedgingTaking a derivative position that moves opposite to an exposure you already have, so gains on one offset losses on the other and the future rate is locked in at a known level.
- Interest rate riskThe risk that an investor in a debt instrument loses return because rates rise — existing instruments carrying the old, lower coupon fall in value until their yield matches the new market rate.
- Forward Rate AgreementAn OTC contract that locks in an interest rate today for a borrowing or lending period starting later; only the rate difference on a notional principal is settled, in cash.
- DerivativeA contract whose value is derived from the value of something else — the underlying — rather than from anything the contract itself owns or produces.
- Interest rate swapAn agreement to exchange streams of interest payments on a notional principal for a set period — typically fixed against floating — where only the net difference ever changes hands.
- Interest Rate FuturesA standardised exchange-traded contract to buy or sell a notional government security, or an interest rate itself, at a price agreed today for settlement on a future date.