Interest rate derivative

In finance, an interest rate derivative (IRD) is a derivative whose payments are determined through calculation techniques where the underlying benchmark product is an interest rate, or set of different interest rates. There are a multitude of different interest rate indices that can be used in this definition.

IRDs are popular with all financial market participants given the need for almost any area of finance to either hedge or speculate on the movement of interest rates.

Modeling of interest rate derivatives is usually done on a time-dependent multi-dimensional lattice ("tree") or using specialized simulation models. Both are calibrated to the underlying risk drivers, usually domestic or foreign short rates and foreign exchange market rates, and incorporate delivery- and day count conventions. The Heath–Jarrow–Morton framework is often used instead of short rates.

Types

The most basic subclassification of interest rate derivatives (IRDs) is to define linear and non-linear.

Further classification of the above is then made to define vanilla (or standard) IRDs and exotic IRDs; see exotic derivative.

Linear and non-linear

Linear IRDs are those whose net present values (PVs) are overwhelmingly (although not necessarily entirely) dictated by and undergo changes approximately proportional to the one-to-one movement of the underlying interest rate index. Examples of linear IRDs are; interest rate swaps (IRSs), forward rate agreements (FRAs), zero coupon swaps (ZCSs), cross-currency basis swaps (XCSs) and single currency basis swaps (SBSs).