Interest rate futures, options, swaps, and forward rate agreements

¶ … risk management tools: interest rate futures, interest rate options, forward rate agreement and interest rate swaps.

Interest Rate Futures

An interest rate futures contract is a financial derivative. It allows the buyer of the contract to lock in a future investment rate. Like all derivatives, interest rate futures are based on an underlying security, which is a debt obligation that moves in value as interest rates change (Ord, 2011).

The interest rate future is a contract between the buyer and the seller in which they agree to the future delivery of any interest-bearing asset. The interest rate future allows the buyer and seller to lock in the price of the interest-bearing asset for a future date.

Some examples of underlying instruments of interest rate futures include:

Treasury bills in the case of Treasury bill futures traded on the Chicago Mercantile Exchange (CME)

Treasury bonds in the case of Treasury bond futures traded on the Chicago Board of Trade (CBT)

Other products such as CDs, treasury notes and Ginnie Mae's are also available to be traded as underlying assets in an interest rate future

Given how large in size interest rate futures are -- for example, $1 million for treasury bills -- they are not considered a product for the less sophisticated trader (Investopedia, 2011).

When interest rates move higher, the buyer of the futures contract pays the seller an amount equal to the benefit received by investing at a higher rate vs. that of the rate specified in the futures contract. Conversely, when interest rates move lower, the seller of the futures contract will compensate the buyer for the lower interest rate at the time of expiration. (Ord, 2011).

Interest Rate Options

An interest rate option is an investment tool whose payoff depends on the future level of interest rates. Interest rate options are both exchange traded and over-the-counter instruments. Interest rate options from exchanges in the U.S. are offered on Treasury bond futures, Treasury note futures, and Eurodollar futures. An investor who takes a long position in interest rate call options believes that interest rates will rise; and investor who takes a position in interest rate put options believes that interest rates will fall (Investopedia, 2011).

An interest rate option is an option contract that gives the holder the right to buy, for a call, or sell, for a put, a security with a certain interest rate at a given strike price on or before the expiration date. An interest option is useful to hedge the interest risk inherent to portfolios consisting mainly of bonds (Farlex, 2009).

With interest rate options the underlying is not an asset, it is an interest rate. The underlying can be thought of as an interest payment. Interest rate options are by definition cash settled (Chance, 2008).

Interest Rate Swaps

An interest rate swap is an agreement between two counterparties where one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps often exchange a fixed payment for a floating payment that is linked to an interest rate, most often the LIBOR. A company typically uses interest rate swaps to limit or manage exposure to fluctuations in interest rates, or to obtain a marginally lower interest rate than it would have been able to get without the swap (Investopedia, 2011).

Interest rate swaps are basically the exchange of one set of cash flows for another, based on interest rate specifications. Because they trade OTC, they are really just contracts set up between two or more parties and can therefore be customized in various ways (Investopedia, 2011).

In general, swaps are sought by firms that want a type of interest structure that another firm can provide less expensively. For example, Firm A is seeking to loan funds at a fixed interest rate, but Firm B. has access to marginally cheaper funds. Firm B. can issue debt to investors at its low fixed rate, and then trade the fixed rate cash flow obligations to Firm A for floating rate obligations issued by Firm B. Even though Firm B. may have a higher floating rate than Firm A, by swapping the interest rate structures they are best able to obtain, their combined costs are decreased, resulting in a benefit that both parties share (Investopedia, 2011).

The most popular interest rate swaps are fixed-for-floating swaps, and among these, the most common use a 3-month or 6-month LIBOR rate (or EURIBOR if the currency is the Euro) as their floating rate. These are called vanilla interest rate swaps. There is also a liquid market for floating-floating interest rate swaps, which are known as basis swaps (Holton, 2005).