Interest rate derivative

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An interest rate derivative is a derivative where the underlying asset is the right to pay or receive a (usually notional) amount of money at a given interest rate.

Interest rate derivatives are the largest derivatives market in the world. Market observers estimate that $60 trillion dollars by notional value of interest rate derivatives contract had been exchanged by May 2004.

According to the International Swaps and Derivatives Association, 80% of the world's top 500 companies at April 2003 used interest rate derivatives to control their cashflow. This compares with 75% for foreign exchange options, 25% for commodity options and 10% for stock options.

Budget Cap

A Low Cost Tool for Controlling Interest Rate Risk

When most companies think of hedging against rising interest rates, their real concern is mitigating the impact of rising rates on the actual dollar interest payments on outstanding loans and debt issues. Conventional interest rate caps establish a maximum interest rate (i.e. the strike rate) for each interest period and protect not only against sustained high levels of interest rates but also against sharply higher rates in a single interest period. Protecting against the latter effect, however, adds to hedging costs. Hedges which protect against sustained but not transitory rate moves are considerably cheaper than traditional hedges.

A Budget Cap is designed to hedge a company’s exposure only to sustained interest rate movements. It establishes a maximum total dollar interest amount the hedger will pay out over the life of the cap. By hedging dollar interest payments over a longer time horizon, a company hedges its core interest rate exposure at the lowest cost.

How a Budget Cap Works: To establish the terms of the terms of the cap, the hedger determines how much principal to hedge, the maximum (capped) dollar amount of interest over the caps life, and the final maturity of the cap.

For each interest period, the hedged dollar interest amount is determined by the formula:

Hedge Amount * Actual Number of Days in the Period/360

min[Market Libor, Cap Rate]

The dollar interest amounts for each period are then added together or accumulated. At the maturity of the cap, the total hedged dollar interest amount is compared to the actual amount of interest paid out over the hedge period. If the actual dollar interest amount is greater than the hedged dollar interest amount, the difference is payable to the buyer of the budget cap.

Interest rate derivative

See also