Interest rate derivatives are financial instruments.
To understand interest rate derivatives, you need to have a basic understanding of derivatives and the concept of underlying assets. The concept is not too difficult to understand once you strip away financial jargon. Interest rate derivatives are the most commonly traded in the derivatives markets.
Terms
The first terms to understand are security and commodity. An example of a security is a stock (as in the stock market), and an example of a commodity is corn, oil or gold; it is something of value that is tangible. The next thing to know is underlying asset, or underlier. This is a security or a commodity that is required to be delivered (at a specified price, interest rate or quantity) at a certain time on the basis of a contract that is made between two parties. The contract itself is called a derivative. If there is a contract to deliver 8 bushels of corn at $8 a bushel, then the contract is the derivative and the underlier is corn. In the world of finance, these contracts, or derivatives, can be bought and sold just like any other financial instrument.
Interest Rate Derivatives
An interest rate derivative is simply a derivative (contract) that stipulates the right to pay or receive an amount of money at a given interest rate. Derivatives are used in an investing strategy known as hedging. In a broad sense, a hedge investment is meant to cover the loss of a previous investment, should it not pan out the way the investor hopes it will.
Interest Rate Swap
A "swap" is a derivative in which one party exchanges a stream of interest payments for someone else's stream of cash flows. There are many types of interest rate swaps, and many of them are created to meet an investor's needs. The particulars of any interest rate swap can seem complex unless you are versed in the many finance terms associated with them.
Forward Rate Agreement
In essence, a forward rate agreement (FRA) is a contract between parties that stipulates a fixed rate of interest to be paid or received at a future date. What is unique about these agreements is that at the end of the time period, when the money is due, only the differential between the fixed interest rate and the future interest rate is paid.
Interest Rate Future
The term interest rate future simply means a derivative that agrees to future delivery of any interest-bearing asset. These futures contracts are usually very large and are used with treasury bills, treasury bonds and certificates of deposit.
