Interest-Rate Derivative

What is an 'Interest-Rate Derivative'

An interest-rate derivative is a financial instrument based on an underlying financial security whose value is affected by changes in interest rates. Interest-rate derivatives are hedges used by institutional investors such as banks to combat the changes in market interest rates. Individual investors are more likely to use interest-rate derivatives as a speculative tool - they hope to profit from their guesses about which direction market interest rates will move.

BREAKING DOWN 'Interest-Rate Derivative'

A plain vanilla interest-rate swap is the most basic type of interest-rate derivative. Under such an arrangement, there are two parties. Party one receives a stream of interest payments based on a floating interest rate and pays a stream of interest payments based on a fixed rate. Party two receives a stream of fixed interest rate payments and pays a stream of floating interest rate payments. Both streams of interest payments are based on the same amount of notional principal. Through this exchange, or swap, of cash flows, the two parties hope to reduce uncertainty and the threat of loss from changes in market interest rates. Other types of interest-rate derivatives include eurostrips, swaptions and interest rate call options, to name just a few.

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RELATED FAQS
  1. What is the difference between derivatives and swaps?

    Find out more about derivative securities, swaps, examples of derivatives and swaps, and the main difference between derivative ... Read Answer >>
  2. How can an investor reduce interest rate risk?

    Learn about the different ways investors can reduce interest rate risk. Locking in interest rates increases certainty for ... Read Answer >>
  3. What does the notional principal of a derivative contract refer to?

    Find out more about the notional principal amount, interest rate swap agreements and how the notional principal amount in ... Read Answer >>
  4. Can bond traders trade on interest rate swaps?

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  5. What expiry months are typically available for derivatives?

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