View source for Finance:Interest rate derivative

{{Short description|Financial derivative whose payments are based on interest rate(s)}}
In [[Finance:Finance|finance]], an '''interest rate derivative''' ('''IRD''') is a [[Finance:Derivative|derivative]] whose payments are determined through calculation techniques where the underlying benchmark product is an [[Finance:Interest rate|interest rate]], or set of different interest rates. There are a multitude of different interest rate indices that can be used in this definition.

IRDs are popular with all financial market participants given the need for almost any area of finance to either [[Finance:Hedge|hedge]] or [[Finance:Speculation|speculate]] on the movement of interest rates.

[[Finance:Financial modeling#Quantitative finance|Modeling]] of interest rate derivatives is usually done on a time-dependent multi-dimensional [[Finance:Lattice model#Interest rate derivatives|lattice]] ("tree") or using [[Monte Carlo methods for option pricing|specialized simulation models]]. Both are calibrated to the [[Finance:Underlying|underlying]] risk drivers, usually domestic or foreign [[Finance:Short-rate model|short rates]] and [[Finance:Foreign exchange market|foreign exchange market]] rates, and incorporate delivery- and [[Finance:Day count convention|day count convention]]s. The [[Finance:Heath–Jarrow–Morton framework|Heath–Jarrow–Morton framework]] is often used instead of short rates.

==Types==

The most basic subclassification of interest rate derivatives (IRDs) is to define '''linear''' and '''non-linear'''.
Further classification of the above is then made to define '''vanilla''' (or standard) IRDs and '''exotic''' IRDs; see [[Finance:Exotic derivative|exotic derivative]].

===Linear and non-linear===
Linear IRDs are those whose net present values (PVs) are overwhelmingly (although not necessarily entirely) dictated by and undergo changes approximately proportional to the one-to-one movement of the underlying interest rate index. Examples of linear IRDs are; [[Finance:Interest rate swap|interest rate swaps (IRSs)]], [[Finance:Forward rate agreement|forward rate agreements (FRAs)]], [[Finance:Zero coupon swap|zero coupon swaps (ZCSs)]], [[Finance:Cross currency swap|cross-currency basis swaps (XCSs)]] and single currency basis swaps (SBSs).

Non-linear IRDs form the set of remaining products. Those whose PVs are commonly dictated by more than the one-to-one movement of the underlying interest rate index. Examples of non-linear IRDs are; [[Finance:Swaption|swaption]]s, interest rate caps and floors and [[Finance:Constant maturity swap|constant maturity swaps (CMSs)]]. These products' PVs are reliant upon volatility so their pricing is often more complex as is the nature of their risk management.

===Vanilla and exotic===
The categorisation of linear and non-linear and vanilla and exotic is not universally acknowledged and a number of products might exist that can be arguably assigned to different categories. These terms may also overlap. 
"Vanilla", in "vanilla IRSs" and "vanilla swaptions", is often taken to mean the basic, most liquid and commonly traded variants of those products.

Exotic is usually used to define a feature that is an extension to an IRD type. For example, an in-arrears IRS is a genuine example of an exotic IRS, whereas an IRS whose structure was the same as vanilla but whose start and end dates might be unconventional, would not generally be classed as exotic. Typically this would be referred to as a bespoke IRS (or customised IRS). Bermudan swaptions are examples of swaption extensions that qualify as exotic variants. 

Other products that are generally classed as exotics are power reverse dual currency note (PRDC or Turbo), target redemption note (TARN), CMS steepener [http://www.risk.net/asia-risk/feature/1496874/rate-steepeners-rise], Snowball (finance),<ref>{{cite web|url=http://www.fincad.com/derivatives-resources/wiki/snowballs.aspx|title=Snowballs|publisher=FINCAD|access-date=24 July 2015}}</ref><ref>{{cite web|url=http://www.bloombergview.com/articles/2014-05-02/portuguese-train-company-was-run-over-by-a-snowball|title=Portuguese Train Company Was Run Over by a Snowball|last=Levine|first=Matt|date=2014-05-02|publisher=Bloomberg|access-date=24 July 2015}}</ref> [[Finance:Inverse floating rate note|Inverse floater]], [[Finance:Zero-coupon bond|Strips]] of [[Finance:Collateralized mortgage obligation|Collateralized mortgage obligation]], Ratchet caps and floors, and Cross currency swaptions.

==Trivia==

The interest rate [[Finance:Derivatives market|derivatives market]] is the largest derivatives market in the world. The [[Organization:Bank for International Settlements|Bank for International Settlements]] estimates that the [[Finance:Notional amount|notional amount]] outstanding in June 2012<ref>Bank for International Settlements [http://www.bis.org/statistics/otcder/dt1920a.csv "Semiannual OTC derivatives statistics"] at end-June 2012. Retrieved 5 July 2013.</ref> were US$494 trillion for [[Finance:Over-the-counter|OTC]] interest rate contracts, and US$342 trillion for [[Finance:Over-the-counter|OTC]] [[Finance:Interest rate swap|interest rate swap]]s. According to the [[Organization:International Swaps and Derivatives Association|International Swaps and Derivatives Association]], 80% of the world's top 500 companies as of April 2003 used interest rate derivatives to control their cashflows. This compares with 75% for [[Finance:Foreign exchange option|foreign exchange option]]s, 25% for [[Finance:Commodity|commodity]] options and 10% for stock options.

==See also==
*[[Finance:Financial modeling|Financial modeling]]
*[[Finance:Mathematical finance|Mathematical finance]]
*[[Finance:Multi-curve framework|Multi-curve framework]]

==References==
{{Reflist}}

==Further reading==
*{{cite book | title = Pricing and Trading Interest Rate Derivatives | author = J H M Darbyshire | year = 2017 | edition = 2nd ed. 2017 | url = http://www.tradinginterestrates.com | isbn = 978-0995455528 | publisher = Aitch and Dee Ltd.}}
*{{cite book | title = Interest Rate Modeling in Three Volumes | author = Leif B.G. Andersen, Vladimir V. Piterbarg | year = 2010 | edition = 1st ed. 2010 | url = http://www.andersen-piterbarg-book.com | isbn = 978-0-9844221-0-4 | publisher = Atlantic Financial Press | url-status = dead | archive-url = https://web.archive.org/web/20110208161936/http://andersen-piterbarg-book.com/ | archive-date = 8 February 2011 | df = dmy-all }}
*{{cite book | title = Interest Rate Models - Theory and Practice with Smile, Inflation and Credit| author = Damiano Brigo, Fabio Mercurio | publisher = Springer Verlag | year = 2001 | edition = 2nd ed. 2006 | isbn = 978-3-540-22149-4}}
*John C. Hull (2005) ''Options, Futures and Other Derivatives'', Sixth Edition. Prentice Hall. {{ISBN|0-13-149908-4}}
* John F. Marhsall (2000). ''Dictionary of Financial Engineering''. Wiley. {{ISBN|0-471-24291-8}}

==External links==
*[http://www.financial-edu.com/basic-fixed-income-derivative-hedging.php Basic Fixed Income Derivative Hedging] - Article on Financial-edu.com.
*[https://web.archive.org/web/20110208161936/http://andersen-piterbarg-book.com/ Interest Rate Modeling] by L. Andersen and V. Piterbarg
*[http://www.tradinginterestrates.com Pricing and Trading Interest Rate Derivatives] by J H M Darbyshire
*[https://www.opencminc.com Online Analytics and Portfolio Management Tools] by OCM Solutions Inc.
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[[Category:Derivatives (finance)]]

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