The Handbook of Financial Instruments

Chapter 29 Interest Rate Derivatives

Frank J. Fabozzi, Ph.D., CFA

Adjunct Professor of Finance School of Management Yale University

Steven V. Mann, Ph.D.

Professor of Finance The Moore School of Business University of South Carolina

The previous chapter covered the role of derivatives in portfolio management, the different types of derivatives, and the valuation of derivatives. In the description of the types of derivatives, the difference in the risk and return characteristics of futures-type products and option-type products was described, as well as the distinction between exchange-traded products and over-the-counter products. The focus in the previous chapter was on equity derivatives.

In this chapter we look at interest rate derivatives. We will not repeat the fundamental characteristics of derivatives. Instead, we will look at the derivative products available in the market for controlling interest rate risk. The chapter is divided into four sections for each type of derivative: futures/forward contracts, options, swaps, and caps/floors.

INTEREST RATE FUTURES

A futures contract is an agreement that requires each party to the agreement either to buy or sell something at a designated future date at a predetermined price. A forward contract, just like a futures contract, is an agreement for the future delivery of something at a specified price at the end of a designated period of time. Futures contracts are standardized agreements as to the delivery date (or month) and ...