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The Money Markets Handbook: A Practitioner's Guide by Moorad Choudhry

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CHAPTER 5

Money market derivatives

Participants in the money markets use a variety of derivative instruments for the purposes of trading and hedging. These are primarily interest-rate derivatves. The market in short-term interest-rate derivatives is large and liquid, and the instruments involved are used by both financial institutions and corporates. In this chapter we review the two main contracts used in money markets trading, the short-term interest rate future and the forward rate agreement. Money market derivatives are priced on the basis of the forward rate, and are flexible instruments for hedging against or speculating on forward interest rates. The FRA and the exchange-traded interest-rate future both date from around the same time, and although initially developed to hedge forward interest-rate exposure, they now have a variety of uses. In this chapter the instruments are introduced and analysed, and there is a review of their main uses. We also consider a more recent addition to the money markets, the overnight-interest rate swap, known as the overnight-index swap or OIS swap. This is sometimes called a basis swap, but this term should be used really for swaps whose legs have different bases such as different currencies to them.

Forward rate agreements

A forward rate agreement (FRA) is an over-the-counter (OTC) derivative instrument that trades as part of the money markets. It is essentially a forward-starting loan, but with no exchange of principal, so that only the ...

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