Equity Derivative

7/31/2019 Equity Derivative

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Equity derivative

From Wikipedia, the free encyclopedia

Infinance, an equity derivative is a class ofderivativeswhose value is at least

partly derived from one or moreunderlyingequitysecurities.Optionsandfuturesare by farthe most common equity derivatives, however there aremany other types of equity

derivativesthat are actively traded.

Contents

[hide]

1 Equity options

2 Warrants

3 Convertible bonds

4 Equity futures, options and swaps

o 4.1 Stock market index futureso 4.2 Equity basket derivativeso 4.3 Single-stock futureso 4.4 Equity index swapso 4.5 Equity swap

5 Exchange-traded derivatives6 References

[edit]Equity options

Main article:Option (finance)

Equity options are the most common type of equity derivative.[1]They provide the right, but

not the obligation, to buy (call) or sell (put) a quantity of stock (1 contract = 100 shares of

stock), at a set price (strike price), within a certain period of time (prior to the expiration

date).

[edit]Warrants

Main article:Warrant (finance)

Infinance, a warrant is asecuritythat entitles the holder to buy stock of the company that

issued it at a specified price, which is much lower than the stock price at time of issue.

Warrants are frequently attached to bonds or preferred stock as a sweetener, allowing the

issuer to pay lower interest rates or dividends. They can be used to enhance theyieldof the

bond, and make them more attractive to potential buyers.
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rivative#Convertible_bondshttp://en.wikipedia.org/wiki/Equity_derivative#Warrantshttp://en.wikipedia.org/wiki/Equity_derivative#Equity_optionshttp://en.wikipedia.org/wiki/Equity_derivativehttp://en.wikipedia.org/wiki/List_of_finance_topics#Equity_derivativeshttp://en.wikipedia.org/wiki/List_of_finance_topics#Equity_derivativeshttp://en.wikipedia.org/wiki/Future_(finance)http://en.wikipedia.org/wiki/Option_(finance)http://en.wikipedia.org/wiki/Securitieshttp://en.wikipedia.org/wiki/Stockhttp://en.wikipedia.org/wiki/Underlyinghttp://en.wikipedia.org/wiki/Derivative_(finance)http://en.wikipedia.org/wiki/Finance


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[edit]Convertible bonds

Main article:Convertible bond

Convertible bonds are bonds that can be converted into shares ofstockin the

issuingcompany, usually at some pre-announced ratio. It is ahybrid securitywith debt- and

equity-like features. It can be used by investors to obtain the upside of equity-like returns

while protecting the downside with regular bond-like coupons.

[edit]Equity futures, options and swaps

Investors can gain exposure to the equity markets using futures, options and swaps. These

can be done on single stocks, a customized basket of stocks or on an index of stocks. These

equity derivatives derive their value from the price of the underlying stock or stocks.

[edit]Stock market index futures

Main article:Stock market index future

Stock market index futures are futures contracts used to replicate the performance of an

underlyingstock market index. They can be used for hedging against an existing equity

position, or speculating on future movements of the index. Indices for futures include well-

established indices such asS&P,FTSE,DAX,CAC40and otherG12country indices. Indices

for OTC products are broadly similar, but offer more flexibility.[vague]...

[edit]Equity basket derivatives

Equity basket derivatives are futures, options or swaps where the underlying is a non-index

basket of shares. They have similar characteristics to equity index derivatives, but are always

traded OTC (over the counter, i.e. between established institutional investors),[dubiousdiscuss] as

the basket definition is not standardized in the way that an equity index is.

These are used normally for correlation trading.

Futures contract

Infinance, a futures contract is a standardizedcontractbetween two parties to buy or sell a

specified asset of standardized quantity and quality for a price agreed today (thefutures

price orstrike price) with delivery and payment occurring at a specified future date,

the delivery date. The contracts are negotiated at afutures exchange, which acts as an

intermediary between the two parties. The party agreeing to buy the underlying asset in the

future, the "buyer" of the contract, is said to be "long", and the party agreeing to sell the asset

in the future, the "seller" of the contract, is said to be "short". The terminology reflects the
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expectations of the partiesthe buyer hopes or expects that the asset price is going to

increase, while the seller hopes or expects that it will decrease.

Option (finance)

Infinance, an option is aderivativefinancial instrumentthat specifies a contract between

two parties for a future transaction on an asset at a reference price (the strike).[1]The buyer of

the option gains the right, but not the obligation, to engage in that transaction, while the

seller incurs the corresponding obligation to fulfill the transaction. The price of an option

derives from the difference between the reference price and the value of theunderlyingasset

(commonly astock, abond, acurrencyor afutures contract) plus a premium based on the

time remaining until the expiration of the option. Other types of options exist, and options

can in principle be created for any type of valuable asset.

Fixed income


Financial markets

Public market

Exchange Securities

Bond market

Bond valuation Corporate bond Fixed income

Government bond High-yield debt Municipal bond
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Stock market

Common stock Preferred stock Registered share

Stock Stock certificate Stock exchange Voting shareDerivatives market

Credit derivative Futures exchange Hybrid security Securitization

Over-the-counter

Forwards Options

Spot market Swaps

Foreign exchange

Currency Exchange rate

Other markets

Commodity market Money market

Reinsurance market Real estate market

Practical trading

Clearing houseFinancial market participants

Financial regulation
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Financeseries

Banks and banking Corporate finance Personal finance Public finance

V

T

EFixed income refers to any type ofinvestmentthat is notequity, which obligates the

borrower/issuer to make payments on a fixed schedule, even if the number of the payments

may be variable.

For example, if you lend money to a borrower and the borrower has to payinterestonce a

month, you have been issued a fixed-incomesecurity. Governments issuegovernment

bondsin their own currency andsovereign bondsin foreign currencies. Local governments

issuemunicipal bondsto finance themselves. Debt issued by government-backed agencies is

called anagency bond. Companies can issue acorporate bondor get money from a bank

through acorporate loan("preferred stock" can be "fixed income" in some contexts).

Securitized bank lending (e.g. credit card debt, car loans or mortgages) can be structured

into other types of fixed income products such as ABS asset-backed securitieswhich can be

traded on exchanges just like corporate and government bonds.

The term fixed income is also applied to a person's income that does not vary with each

period. This can include income derived from fixed-income investments such as bonds

andpreferred stocksorpensionsthat guarantee a fixed income. When pensioners or retirees

are dependent on their pension as their dominant source of income, the term "fixed income"

can also carry the implication that they have relatively limiteddiscretionary incomeor have

little financial freedom to make large expenditures.

Fixed-income securities can be contrasted with equity securities that create no obligation to

pay dividends, such asstocks. In order for a company to grow as a business, it often must

raise money; to finance an acquisition, buy equipment or land or invest in new product

development. Investors will give money to the company only if they believe that they will

be given something in return commensurate with the risk profile of the company. The

company can either pledge a part of itself, by givingequityin the company (stock), or the
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company can give a promise to pay regularinterestand repay principal on the loan (bond,

bank loan, or preferred stock).

The term "fixed" in "fixed income" refers only to the schedule of obligatory payments, not

the amount. "Fixed income securities" include inflation linked bonds, variable-interest ratenotes, and the like. If an issuer misses a payment on a fixed income security, the issuer is

indefault, and the payees can force the issuer into bankruptcy. In contrast, if a company

misses a quarterly dividend to stock (non-fixed-income) shareholders, there is no violation

of any payment covenant, and no default.

Contents

[hide]

1 Terminology

2 Investors

3 Pricing factors

4 Inflation-linked bonds

5 Derivatives

6 Risks

7 See also

8 References

9 External links

[edit]Terminology

While a bond is simply a promise to pay interest on borrowed money, there is some

important terminology used by the fixed-income industry:

Theissueris the entity (company or govt.) who borrows an amount of money (issuingthe bond) and pays the interest.

Theprincipalof a bond also known as maturity value, face value, par value is theamount that the issuer borrows which must be repaid to the lender.[1]

Thecoupon(of a bond) is the interest that the issuer must pay. Thematurityis the end of the bond, the date that the issuer must return the principal. The issue is another term for the bond itself. Theindentureis the contract that states all of the terms of the bond.[edit]Investors

Investors in fixed-income securities are typically looking for a constant and secure return ontheir investment. For example, a retired person might like to receive a regular dependable
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payment to live on, but not consume principal. This person can buy a bond with their

money, and use the coupon payment (the interest) as that regular dependable payment.

When the bond matures or is refinanced, the person will have their money returned to them.

[edit]Pricing factors

Fixed income investments such as bonds and loans are generally priced as a credit spread

above a low-risk reference rate, such as LIBOR or U.S. or German Government Bonds of the

same duration.[2]For example, if a 30 year mortgage is available for 5% and 30 year U.S.

treasuries yield 3%, the credit spread is 2%. The credit spread reflects the risk of default and

profits for lenders, while the low-risk reference rate reflects other factors that may drive

interest rates.[2]Risk free Interest rates change over time, based on a variety of factors,

particularlybase ratesset bycentral bankssuch as the USFederal Reserve, UKBank of

England, and Euro ZoneECB. If the coupon on the bond is lower than the prevailing interestrate, then this pushes the price down, and conversely, low interest rates increase the

attractiveness of a given coupon, and so increase the price.

In buying a bond, one is in effect buying a set of cash flows, which are discounted according

to the buyer's perception of how interest and exchange rates will move over its life.

Supply and demand affect prices, especially in the case of market participants which are

constrained in the set of investments they make. Insurance companies often have long term

liabilities that they wish to hedge, which requires low risk, predictable cash flows, such as

long dated government bonds.

[edit]Inflation-linked bonds

There are alsoinflation-indexed bonds, fixed-income securities linked to a specific price

index. The most common examples are USTreasury Inflation Protected Securities(TIPS) and

UK Index LinkedGilts. This type of fixed income is adjusted to aConsumer Price Index(in

the US this is the CPI-U for urban consumers), and then a real yield is applied to the

adjusted principal. This means that these bonds are guaranteed to outperform the inflation

rate (unless the government defaults on the bond). This allows investors of all sizes to not

lose the purchasing power of their money due to inflation, which can be very uncertain at

times. For example, assuming 3.88% inflation over the course of 1 year (just about the 56

year average inflation rate, through most of 2006), and a real yield of 2.61% (the fixed US

Treasury real yield on October 19, 2006, for a 5 yr TIPS), the adjusted principal of the fixed

income would rise from 100 to 103.88 and then the real yield would be applied to the

adjusted principal, meaning 103.88 x 1.0261, which equals 106.5913; giving a total return of

6.5913%. TIPS moderately outperform conventional US Treasuries, which yielded just 5.05%

for a 1 yr bill on October 19, 2006.
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[edit]Derivatives

Fixed income derivatives includeinterest rate derivativesandcredit derivatives.

Ofteninflation derivativesare also included into this definition. There is a wide range of

fixed income derivative products:options,swaps,futures contractsas well asforwardcontracts. The most widely traded kinds are:

Credit default swaps[3] Interest rate swaps Inflation swaps Bond futureson 2/10/30-year government bonds Interest rate futureson 90-day interbank interest rates

Forward rate agreements[edit]Risks

Fixed income securities from any entity have risks that may include but are not limited to:

inflationary risk that the buying power of the principal will decline during the term ofthe security

interest rate risk that overall interest rates will change from the levels extant when thesecurity is sold, causing an opportunity cost

currency risk that exchange rates with other currencies will change during thesecurity's term, causing loss of buying power in other countries

default risk that the issuer will be unable to pay the scheduled interest payments dueto financial hardship

repayment of principal risk that the issuer will be unable to repay the principal due tofinancial hardship

reinvestment risk that the purchaser will be unable to purchase another security ofsimilar return upon the expiration of the current security

liquidity risk that the buyer will require the principal funds for another purpose onshort notice, prior to the expiration of the security, and be unable to exchange the

security for cash in the required time period without loss of fair value

maturity risk this is another name for interest rate risk streaming income payment risk duration risk convexity risk credit quality risk
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political risk that governmental actions will cause the owner to lose the benefits of thesecurity

tax adjustment risk market risk the risk of market-wide changes affecting the value of the security climate risk event risk the risk that externalities will cause the owner to lose the benefits of the

security

Interest rate derivative


An interest rate derivative is aderivativewhere the underlying asset is the right to pay or

receive anotional amountofmoneyat a giveninterest rate. These structures are popular for

investors with customized cashflow needs or specific views on the interest rate movements

(such as volatility movements or simple directional movements) and are therefore usually

tradedOTC; seefinancial engineering.

The interest ratederivatives marketis the largest derivatives market in the world. TheBank

for International Settlementsestimates that thenotional amountoutstanding in June

2009[1]were US$437 trillion forOTCinterest rate contracts, and US$342 trillion

forOTCinterest rate swaps. According to theInternational 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% forforeign exchange options,

25% forcommodityoptions and 10% forstock options.

Modelingof interest rate derivatives is usually done on a time-dependentmulti-

dimensionalLattice("tree") built for theunderlyingrisk drivers, usually domestic or

foreignshort ratesandforeign exchange marketrates, and incorporating delivery- andday

count conventions; seeShort-rate model.Specialised simulation modelsare also often used.
http://en.wikipedia.org/w/index.php?title=Tax_adjustment_risk&action=edit&redlink=1http://en.wikipedia.org/w/index.php?title=Tax_adjustment_risk&action=edit&redlink=1http://en.wikipedia.org/wiki/Climate_riskhttp://en.wikipedia.org/wiki/Climate_riskhttp://en.wikipedia.org/wiki/Derivative_(finance)http://en.wikipedia.org/wiki/Derivative_(finance)http://en.wikipedia.org/wiki/Derivative_(finance)http://en.wikipedia.org/wiki/Notional_amounthttp://en.wikipedia.org/wiki/Notional_amounthttp://en.wikipedia.org/wiki/Notional_amounthttp://en.wikipedia.org/wiki/Moneyhttp://en.wikipedia.org/wiki/Moneyhttp://en.wikipedia.org/wiki/Moneyhttp://en.wikipedia.org/wiki/Interest_ratehttp://en.wikipedia.org/wiki/Interest_ratehttp://en.wikipedia.org/wiki/Interest_ratehttp://en.wikipedia.org/wiki/Over-the-counter_(finance)http://en.wikipedia.org/wiki/Over-the-counter_(finance)http://en.wikipedia.org/wiki/Over-the-counter_(finance)http://en.wikipedia.org/wiki/Financial_engineeringhttp://en.wikipedia.org/wiki/Financial_engineeringhttp://en.wikipedia.org/wiki/Financial_engineeringhttp://en.wikipedia.org/wiki/Derivatives_markethttp://en.wikipedia.org/wiki/Derivatives_markethttp://en.wikipedia.org/wiki/Derivatives_markethttp://en.wikipedia.org/wiki/Bank_for_International_Settlementshttp://en.wikipedia.org/wiki/Bank_for_International_Settlementshttp://en.wikipedia.org/wiki/Bank_for_International_Settlementshttp://en.wikipedia.org/wiki/Bank_for_International_Settlementshttp://en.wikipedia.org/wiki/Notional_amounthttp://en.wikipedia.org/wiki/Notional_amounthttp://en.wikipedia.org/wiki/Notional_amounthttp://en.wikipedia.org/wiki/Interest_rate_derivative#cite_note-0http://en.wikipedia.org/wiki/Interest_rate_derivative#cite_note-0http://en.wikipedia.org/wiki/Interest_rate_derivative#cite_note-0http://en.wikipedia.org/wiki/Over-the-counter_(finance)http://en.wikipedia.org/wiki/Over-the-counter_(finance)http://en.wikipedia.org/wiki/Over-the-counter_(finance)http://en.wikipedia.org/wiki/Over-the-counter_(finance)http://en.wikipedia.org/wiki/Over-the-counter_(finance)http://en.wikipedia.org/wiki/Interest_rate_swaphttp://en.wikipedia.org/wiki/Interest_rate_swaphttp://en.wikipedia.org/wiki/Interest_rate_swaphttp://en.wikipedia.org/wiki/International_Swaps_and_Derivatives_Associationhttp://en.wikipedia.org/wiki/International_Swaps_and_Derivatives_Associationhttp://en.wikipedia.org/wiki/International_Swaps_and_Derivatives_Associationhttp://en.wikipedia.org/wiki/International_Swaps_and_Derivatives_Associationhttp://en.wikipedia.org/wiki/Foreign_exchange_optionhttp://en.wikipedia.org/wiki/Foreign_exchange_optionhttp://en.wikipedia.org/wiki/Foreign_exchange_optionhttp://en.wikipedia.org/wiki/Commodityhttp://en.wikipedia.org/wiki/Commodityhttp://en.wikipedia.org/wiki/Commodityhttp://en.wikipedia.org/wiki/Stock_optionhttp://en.wikipedia.org/wiki/Stock_optionhttp://en.wikipedia.org/wiki/Stock_optionhttp://en.wikipedia.org/wiki/Financial_modeling#Quantitative_financehttp://en.wikipedia.org/wiki/Financial_modeling#Quantitative_financehttp://en.wikipedia.org/wiki/Multi-dimensionalhttp://en.wikipedia.org/wiki/Multi-dimensionalhttp://en.wikipedia.org/wiki/Multi-dimensionalhttp://en.wikipedia.org/wiki/Lattice_model_(finance)http://en.wikipedia.org/wiki/Lattice_model_(finance)http://en.wikipedia.org/wiki/Lattice_model_(finance)http://en.wikipedia.org/wiki/Underlyinghttp://en.wikipedia.org/wiki/Underlyinghttp://en.wikipedia.org/wiki/Underlyinghttp://en.wikipedia.org/wiki/Short_ratehttp://en.wikipedia.org/wiki/Short_ratehttp://en.wikipedia.org/wiki/Short_ratehttp://en.wikipedia.org/wiki/Foreign_exchange_markethttp://en.wikipedia.org/wiki/Foreign_exchange_markethttp://en.wikipedia.org/wiki/Foreign_exchange_markethttp://en.wikipedia.org/wiki/Day_count_conventionhttp://en.wikipedia.org/wiki/Day_count_conventionhttp://en.wikipedia.org/wiki/Day_count_conventionhttp://en.wikipedia.org/wiki/Day_count_conventionhttp://en.wikipedia.org/wiki/Short-rate_modelhttp://en.wikipedia.org/wiki/Short-rate_modelhttp://en.wikipedia.org/wiki/Short-rate_modelhttp://en.wikipedia.org/wiki/Monte_Carlo_methods_for_option_pricinghttp://en.wikipedia.org/wiki/Monte_Carlo_methods_for_option_pricinghttp://en.wikipedia.org/wiki/Monte_Carlo_methods_for_option_pricinghttp://en.wikipedia.org/wiki/Monte_Carlo_methods_for_option_pricinghttp://en.wikipedia.org/wiki/Short-rate_modelhttp://en.wikipedia.org/wiki/Day_count_conventionhttp://en.wikipedia.org/wiki/Day_count_conventionhttp://en.wikipedia.org/wiki/Foreign_exchange_markethttp://en.wikipedia.org/wiki/Short_ratehttp://en.wikipedia.org/wiki/Underlyinghttp://en.wikipedia.org/wiki/Lattice_model_(finance)http://en.wikipedia.org/wiki/Multi-dimensionalhttp://en.wikipedia.org/wiki/Multi-dimensionalhttp://en.wikipedia.org/wiki/Financial_modeling#Quantitative_financehttp://en.wikipedia.org/wiki/Stock_optionhttp://en.wikipedia.org/wiki/Commodityhttp://en.wikipedia.org/wiki/Foreign_exchange_optionhttp://en.wikipedia.org/wiki/International_Swaps_and_Derivatives_Associationhttp://en.wikipedia.org/wiki/International_Swaps_and_Derivatives_Associationhttp://en.wikipedia.org/wiki/Interest_rate_swaphttp://en.wikipedia.org/wiki/Over-the-counter_(finance)http://en.wikipedia.org/wiki/Over-the-counter_(finance)http://en.wikipedia.org/wiki/Interest_rate_derivative#cite_note-0http://en.wikipedia.org/wiki/Notional_amounthttp://en.wikipedia.org/wiki/Bank_for_International_Settlementshttp://en.wikipedia.org/wiki/Bank_for_International_Settlementshttp://en.wikipedia.org/wiki/Derivatives_markethttp://en.wikipedia.org/wiki/Financial_engineeringhttp://en.wikipedia.org/wiki/Over-the-counter_(finance)http://en.wikipedia.org/wiki/Interest_ratehttp://en.wikipedia.org/wiki/Moneyhttp://en.wikipedia.org/wiki/Notional_amounthttp://en.wikipedia.org/wiki/Derivative_(finance)http://en.wikipedia.org/wiki/Climate_riskhttp://en.wikipedia.org/w/index.php?title=Tax_adjustment_risk&action=edit&redlink=1


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Contents

[hide]

1 Typeso 1.1 Vanillao 1.2 Quasi-vanillao 1.3 Exotic derivatives

2 Example of interest rate derivatives

o 2.1 Interest rate capo 2.2 Range accrual noteo 2.3 Bermudan swaption

3 See also

4 References

5 Further reading

6 External links

[edit]Types

[edit]Vanilla

The basic building blocks for most interest rate derivatives can be described as "vanilla"

(simple, basic derivative structures, usually mostliquid):

Interest rate swap(fixed-for-floating) Interest rate capor interest rate floor Interest rateswaption Bond option Forward rate agreement Interest rate future Money marketinstruments Cross currency swap (seeForex swap)[edit]Quasi-vanilla

The next intermediate level is a quasi-vanilla class of (fairly liquid) derivatives, examples of

which are:

Range accrualswaps/notes/bonds In-arrearsswap
http://en.wikipedia.org/wiki/Interest_rate_derivativehttp://en.wikipedia.org/wiki/Interest_rate_derivativehttp://en.wikipedia.org/wiki/Interest_rate_derivativehttp://en.wikipedia.org/wiki/Interest_rate_derivative#Typeshttp://en.wikipedia.org/wiki/Interest_rate_derivative#Typeshttp://en.wikipedia.org/wiki/Interest_rate_derivative#Vanillahttp://en.wikipedia.org/wiki/Interest_rate_derivative#Vanillahttp://en.wikipedia.org/wiki/Interest_rate_derivative#Quasi-vanillahttp://en.wikipedia.org/wiki/Interest_rate_derivative#Quasi-vanillahttp://en.wikipedia.org/wiki/Interest_rate_derivative#Exotic_derivativeshttp://en.wikipedia.org/wiki/Interest_rate_derivative#Exotic_derivativeshttp://en.wikipedia.org/wiki/Interest_rate_derivative#Example_of_interest_rate_derivativeshttp://en.wikipedia.org/wiki/Interest_rate_derivative#Example_of_interest_rate_derivativeshttp://en.wikipedia.org/wiki/Interest_rate_derivative#Interest_rate_caphttp://en.wikipedia.org/wiki/Interest_rate_derivative#Interest_rate_caphttp://en.wikipedia.org/wiki/Interest_rate_derivative#Range_accrual_notehttp://en.wikipedia.org/wiki/Interest_rate_derivative#Range_accrual_notehttp://en.wikipedia.org/wiki/Interest_rate_derivative#Bermudan_swaptionhttp://en.wikipedia.org/wiki/Interest_rate_derivative#Bermudan_swaptionhttp://en.wikipedia.org/wiki/Interest_rate_derivative#See_alsohttp://en.wikipedia.org/wiki/Interest_rate_derivative#See_alsohttp://en.wikipedia.org/wiki/Interest_rate_derivative#Referenceshttp://en.wikipedia.org/wiki/Interest_rate_derivative#Referenceshttp://en.wikipedia.org/wiki/Interest_rate_derivative#Further_readinghttp://en.wikipedia.org/wiki/Interest_rate_derivative#Further_readinghttp://en.wikipedia.org/wiki/Interest_rate_derivative#External_linkshttp://en.wikipedia.org/wiki/Interest_rate_derivative#External_linkshttp://en.wikipedia.org/w/index.php?title=Interest_rate_derivative&action=edit&section=1http://en.wikipedia.org/w/index.php?title=Interest_rate_derivative&action=edit&section=1http://en.wikipedia.org/w/index.php?title=Interest_rate_derivative&action=edit&section=1http://en.wikipedia.org/w/index.php?title=Interest_rate_derivative&action=edit&section=2http://en.wikipedia.org/w/index.php?title=Interest_rate_derivative&action=edit&section=2http://en.wikipedia.org/w/index.php?title=Interest_rate_derivative&action=edit&section=2http://en.wikipedia.org/wiki/Vanilla_optionhttp://en.wikipedia.org/wiki/Vanilla_optionhttp://en.wikipedia.org/wiki/Vanilla_optionhttp://en.wikipedia.org/wiki/Market_liquidityhttp://en.wikipedia.org/wiki/Market_liquidityhttp://en.wikipedia.org/wiki/Market_liquidityhttp://en.wikipedia.org/wiki/Interest_rate_swaphttp://en.wikipedia.org/wiki/Interest_rate_swaphttp://en.wikipedia.org/wiki/Interest_rate_caphttp://en.wikipedia.org/wiki/Interest_rate_caphttp://en.wikipedia.org/wiki/Swaptionhttp://en.wikipedia.org/wiki/Swaptionhttp://en.wikipedia.org/wiki/Swaptionhttp://en.wikipedia.org/wiki/Bond_optionhttp://en.wikipedia.org/wiki/Bond_optionhttp://en.wikipedia.org/wiki/Forward_rate_agreementhttp://en.wikipedia.org/wiki/Forward_rate_agreementhttp://en.wikipedia.org/wiki/Interest_rate_futurehttp://en.wikipedia.org/wiki/Interest_rate_futurehttp://en.wikipedia.org/wiki/Money_markethttp://en.wikipedia.org/wiki/Money_markethttp://en.wikipedia.org/wiki/Forex_swaphttp://en.wikipedia.org/wiki/Forex_swaphttp://en.wikipedia.org/wiki/Forex_swaphttp://en.wikipedia.org/w/index.php?title=Interest_rate_derivative&action=edit&section=3http://en.wikipedia.org/w/index.php?title=Interest_rate_derivative&action=edit&section=3http://en.wikipedia.org/w/index.php?title=Interest_rate_derivative&action=edit&section=3http://en.wikipedia.org/wiki/Range_accrualhttp://en.wikipedia.org/wiki/Range_accrualhttp://en.wikipedia.org/w/index.php?title=In-arrears&action=edit&redlink=1http://en.wikipedia.org/w/index.php?title=In-arrears&action=edit&redlink=1http://en.wikipedia.org/w/index.php?title=In-arrears&action=edit&redlink=1http://en.wikipedia.org/wiki/Range_accrualhttp://en.wikipedia.org/w/index.php?title=Interest_rate_derivative&action=edit&section=3http://en.wikipedia.org/wiki/Forex_swaphttp://en.wikipedia.org/wiki/Money_markethttp://en.wikipedia.org/wiki/Interest_rate_futurehttp://en.wikipedia.org/wiki/Forward_rate_agreementhttp://en.wikipedia.org/wiki/Bond_optionhttp://en.wikipedia.org/wiki/Swaptionhttp://en.wikipedia.org/wiki/Interest_rate_caphttp://en.wikipedia.org/wiki/Interest_rate_swaphttp://en.wikipedia.org/wiki/Market_liquidityhttp://en.wikipedia.org/wiki/Vanilla_optionhttp://en.wikipedia.org/w/index.php?title=Interest_rate_derivative&action=edit&section=2http://en.wikipedia.org/w/index.php?title=Interest_rate_derivative&action=edit&section=1http://en.wikipedia.org/wiki/Interest_rate_derivative#External_linkshttp://en.wikipedia.org/wiki/Interest_rate_derivative#Further_readinghttp://en.wikipedia.org/wiki/Interest_rate_derivative#Referenceshttp://en.wikipedia.org/wiki/Interest_rate_derivative#See_alsohttp://en.wikipedia.org/wiki/Interest_rate_derivative#Bermudan_swaptionhttp://en.wikipedia.org/wiki/Interest_rate_derivative#Range_accrual_notehttp://en.wikipedia.org/wiki/Interest_rate_derivative#Interest_rate_caphttp://en.wikipedia.org/wiki/Interest_rate_derivative#Example_of_interest_rate_derivativeshttp://en.wikipedia.org/wiki/Interest_rate_derivative#Exotic_derivativeshttp://en.wikipedia.org/wiki/Interest_rate_derivative#Quasi-vanillahttp://en.wikipedia.org/wiki/Interest_rate_derivative#Vanillahttp://en.wikipedia.org/wiki/Interest_rate_derivative#Typeshttp://en.wikipedia.org/wiki/Interest_rate_derivative


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Constant maturity swap(CMS) or constant treasury swap (CTS) derivatives (swaps,caps, floors)

Interest rate swapbased upon two floating interest rates[edit]Exotic derivatives

Building off these structures are the "exotic" interest rate derivatives (least liquid, traded

over the counter), such as:

Power Reverse Dual Currencynote (PRDCor Turbo) Target redemption note(TARN) CMS steepener[1] Snowball[2] Inverse floater StripsofCollateralized mortgage obligation Ratchet caps and floors Bermudanswaptions Cross currency swaptionsMost of the exotic interest rate derivatives are structured as swaps or notes, and can be

classified as having two payment legs: a funding leg and an exotic coupon leg.[citation needed]

A funding leg usually consists of series of fixed coupons or floating coupons (LIBOR)plus fixed spread.

An exotic coupon leg typically consists of a functional dependence on the past andcurrent underlying indices (LIBOR, CMS rate, FX rate) and sometimes on its own past

levels, as in Snowballs and TARNs. The payer of the exotic coupon leg usually has a

right to cancel the deal on any of the coupon payment dates, resulting in the so-

calledBermudan exercisefeature. There may also be some range-accrual and knock-out

features inherent in the exotic coupon definition.

[edit]Example of interest rate derivatives

[edit]Interest rate cap

Aninterest rate capis designed to hedge a companys maximum exposure to upward

interest rate movements. It establishes a maximum total dollar interest amount the hedger

will pay out over the life of the cap. The interest rate cap is actually a series of individual

interest rate caplets, each being an individual option on the underlying interest rate index.

The interest rate cap is paid for upfront, and then the purchaser realizes the benefit of the

cap over the life of the instrument.
http://en.wikipedia.org/wiki/Constant_maturity_swaphttp://en.wikipedia.org/wiki/Constant_maturity_swaphttp://en.wikipedia.org/wiki/Interest_rate_swaphttp://en.wikipedia.org/wiki/Interest_rate_swaphttp://en.wikipedia.org/w/index.php?title=Interest_rate_derivative&action=edit&section=4http://en.wikipedia.org/w/index.php?title=Interest_rate_derivative&action=edit&section=4http://en.wikipedia.org/w/index.php?title=Interest_rate_derivative&action=edit&section=4http://en.wikipedia.org/wiki/Exotic_derivativeshttp://en.wikipedia.org/wiki/Exotic_derivativeshttp://en.wikipedia.org/wiki/Exotic_derivativeshttp://en.wikipedia.org/wiki/Power_Reverse_Dual_Currencyhttp://en.wikipedia.org/wiki/Power_Reverse_Dual_Currencyhttp://en.wikipedia.org/wiki/PRDChttp://en.wikipedia.org/wiki/PRDChttp://en.wikipedia.org/wiki/PRDChttp://en.wikipedia.org/w/index.php?title=Target_redemption_note&action=edit&redlink=1http://en.wikipedia.org/w/index.php?title=Target_redemption_note&action=edit&redlink=1http://www.risk.net/asia-risk/feature/1496874/rate-steepeners-risehttp://www.risk.net/asia-risk/feature/1496874/rate-steepeners-risehttp://www.risk.net/asia-risk/feature/1496874/rate-steepeners-risehttp://en.wikipedia.org/wiki/Snowball_(finance)http://www.fincad.com/derivatives-resources/wiki/snowballs.aspxhttp://www.fincad.com/derivatives-resources/wiki/snowballs.aspxhttp://www.fincad.com/derivatives-resources/wiki/snowballs.aspxhttp://en.wikipedia.org/wiki/Strip_(finance)http://en.wikipedia.org/wiki/Strip_(finance)http://en.wikipedia.org/wiki/Collateralized_mortgage_obligationhttp://en.wikipedia.org/wiki/Collateralized_mortgage_obligationhttp://en.wikipedia.org/wiki/Collateralized_mortgage_obligationhttp://en.wikipedia.org/wiki/Bermudan_optionhttp://en.wikipedia.org/wiki/Bermudan_optionhttp://en.wikipedia.org/wiki/Wikipedia:Citation_neededhttp://en.wikipedia.org/wiki/Wikipedia:Citation_neededhttp://en.wikipedia.org/wiki/Wikipedia:Citation_neededhttp://en.wikipedia.org/wiki/Bermudan_optionhttp://en.wikipedia.org/wiki/Bermudan_optionhttp://en.wikipedia.org/wiki/Bermudan_optionhttp://en.wikipedia.org/w/index.php?title=Interest_rate_derivative&action=edit&section=5http://en.wikipedia.org/w/index.php?title=Interest_rate_derivative&action=edit&section=5http://en.wikipedia.org/w/index.php?title=Interest_rate_derivative&action=edit&section=5http://en.wikipedia.org/w/index.php?title=Interest_rate_derivative&action=edit&section=6http://en.wikipedia.org/w/index.php?title=Interest_rate_derivative&action=edit&section=6http://en.wikipedia.org/w/index.php?title=Interest_rate_derivative&action=edit&section=6http://en.wikipedia.org/wiki/Interest_rate_caphttp://en.wikipedia.org/wiki/Interest_rate_caphttp://en.wikipedia.org/wiki/Interest_rate_caphttp://en.wikipedia.org/wiki/Interest_rate_caphttp://en.wikipedia.org/w/index.php?title=Interest_rate_derivative&action=edit&section=6http://en.wikipedia.org/w/index.php?title=Interest_rate_derivative&action=edit&section=5http://en.wikipedia.org/wiki/Bermudan_optionhttp://en.wikipedia.org/wiki/Wikipedia:Citation_neededhttp://en.wikipedia.org/wiki/Bermudan_optionhttp://en.wikipedia.org/wiki/Collateralized_mortgage_obligationhttp://en.wikipedia.org/wiki/Strip_(finance)http://www.fincad.com/derivatives-resources/wiki/snowballs.aspxhttp://en.wikipedia.org/wiki/Snowball_(finance)http://www.risk.net/asia-risk/feature/1496874/rate-steepeners-risehttp://en.wikipedia.org/w/index.php?title=Target_redemption_note&action=edit&redlink=1http://en.wikipedia.org/wiki/PRDChttp://en.wikipedia.org/wiki/Power_Reverse_Dual_Currencyhttp://en.wikipedia.org/wiki/Exotic_derivativeshttp://en.wikipedia.org/w/index.php?title=Interest_rate_derivative&action=edit&section=4http://en.wikipedia.org/wiki/Interest_rate_swaphttp://en.wikipedia.org/wiki/Constant_maturity_swap


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[edit]Range accrual note

Suppose a manager wished to take a view that volatility of interest rates will be low. He or

she may gain extrayieldover a regularbondby buying a range accrualnoteinstead. This

note pays interest only if the floating interest rate (i.e.London Interbank Offered Rate) stayswithin a pre-determined band. This note effectively contains an embeddedoptionwhich, in

this case, the buyer of the note has sold to the issuer. This option adds to the yield of the

note. In this way, ifvolatilityremains low, the bond yields more than a standard bond.

[edit]Bermudan swaption

Suppose a fixed-couponcallable bondwas brought to the market by a company. The issuer

however, entered into aninterest rate swapto convert the fixed coupon payments to floating

payments (perhaps based on LIBOR). Since it is callable however, the issuer may redeem the

bond back from investors at certain dates during the life of the bond. If called, this wouldstill leave the issuer with theinterest rate swap. Therefore, the issuer also enters into

Bermudanswaptionwhen the bond is brought to market with exercise dates equal to

callable dates for the bond. If the bond is called, the swaption is exercised, effectively

canceling the swap leaving no more interest rate exposure for the issuer.
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