Interest Rate Derivatives
Derivative is a product whose value is derived from the value of one or more basic variables. The basic variables are underlying assets, index or may be a reference rate and are known as Bases. The asset can be an equity, a currency, a commodity etc.
The classification of the derivatives is done on the basis of the underlying asset such as
- Equity Derivatives
- Forex Derivatives
- Commodity Derivatives
- Interest Rate Derivatives.
The Derivatives includes the following:
- A security that is derived from a debt instrument , share, loan whether secured or unsecured
- A contract that derives its value from the prices.
The derivatives cane be OTC Derivatives or Over The Counter Derivatives or Exchange Traded Market derivatives. They are discussed as follows:
- OTC Derivatives:
In simple words OTC or Over the Counter derivatives are private , bilateral contracts in which the two parties agree on how the trade has to be settled in Future. It is done over the Telephone and is of two kinds viz. Forward and Swaps
- Forwards: This is the simplest derivative instrument. In this a private agreement is held between the two parties and one party (buyer) agrees to buy from other party (seller) an asset at a future date. Here there are two prices play role
- Spot Price: Price when the contract is made.
- Forward Price: Price when the contract matures.
This future date is fixed at the start of the contract. When the date arrives there are two options to settle this contract:
- The forward contract is settled by the physical delivery of the underlying asset by the seller to the buyer.
- Both parties may go for a cash settlement. In the cash settlement if the difference between the spot and forward is paid to the party which is eligible for it.
- Interest Rate Swap:
Interest Rate Swap is an over-the-counter (OTC) derivative instrument available in the currency market where counter parties can exchange a floating payment for a fixed payment and vice-versa related to an interest rate. Most common parties that go for Interest Rate Swaps are the financial institutions going for foreign borrowings with an objective to hedge their interest rate exposure due to fluctuating interest rates