Fixed Income Analysis, Second Edition

CHAPTER 13

INTEREST RATE DERIVATIVE INSTRUMENTS

I. INTRODUCTION

In this chapter we turn our attention to financial contracts that are popularly referred to as interest rate derivative instruments because they derive their value from some cash market instrument or reference interest rate. These instruments include futures, forwards, options, swaps, caps, and floors. In this chapter we will discuss the basic features of these instruments and in the next we will see how they are valued.

Why would a portfolio manager be motivated to use interest rate derivatives rather than the corresponding cash market instruments. There are three principal reasons for doing this when there is a well-developed interest rate derivatives market for a particular cash market instrument. First, typically it costs less to execute a transaction or a strategy in the interest rate derivatives market in order to alter the interest rate risk exposure of a portfolio than to make the adjustment in the corresponding cash market. Second, portfolio adjustments typically can be accomplished faster in the interest rate derivatives market than in the corresponding cash market. Finally, interest rate derivative may be able to absorb a greater dollar transaction amount without an adverse effect on the price of the derivative instrument compared to the price effect on the cash market instrument; that is, the interest rate derivative may be more liquid than the cash market. To summarize: There are three potential advantages ...