Infinance, aninterest rate derivative (IRD) is aderivative whose payments are determined through calculation techniques where the underlying benchmark product is aninterest rate, or set of different interest rates. There are a multitude of differentinterest 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 eitherhedge orspeculate on the movement of interest rates.
Modeling of interest rate derivatives is usually done on a time-dependent multi-dimensionallattice ("tree") or usingspecialized simulation models. Both are calibrated to theunderlying risk drivers, usually domestic or foreignshort rates andforeign exchange market rates, and incorporate delivery- andday count conventions. TheHeath–Jarrow–Morton framework is often used instead of short rates.
The most basic subclassification of interest rate derivatives (IRDs) is to definelinear andnon-linear.Further classification of the above is then made to definevanilla (or standard) IRDs andexotic IRDs; seeexotic derivative.
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) andsingle currency basis swaps (SBSs).
Non-linear IRDs form the set of remaining products. Those whose PVs are commonly dictated by more than the one-to-one movement of the underlying interest rate index. Examples of non-linear IRDs are;swaptions,interest rate caps and floors andconstant maturity swaps (CMSs). These products' PVs are reliant upon volatility so their pricing is often more complex as is the nature of their risk management.
The categorisation of linear and non-linear and vanilla and exotic is not universally acknowledged and a number of products might exist that can be arguably assigned to different categories. These terms may also overlap. "Vanilla", in "vanilla IRSs" and "vanilla swaptions", is often taken to mean the basic, most liquid and commonly traded variants of those products.
Exotic is usually used to define a feature that is an extension to an IRD type. For example, anin-arrears IRS is a genuine example of an exotic IRS, whereas an IRS whose structure was the same as vanilla but whose start and end dates might be unconventional, would not generally be classed as exotic. Typically this would be referred to as a bespoke IRS (or customised IRS).Bermudan swaptions are examples of swaption extensions that qualify as exotic variants.
Other products that are generally classed as exotics arepower reverse dual currency note (PRDC or Turbo),target redemption note (TARN), CMS steepener[1], Snowball (finance),[1][2]Inverse floater,Strips ofCollateralized mortgage obligation, Ratchet caps and floors, and Cross currency swaptions.
The interest ratederivatives market is the largest derivatives market in the world. TheBank for International Settlements estimates that thenotional amount outstanding in June 2012[3] were US$494 trillion forOTC interest 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% forcommodity options and 10% forstock options.
