Interest Rate Derivatives: Features, Valuation and Benefits

Abstract

Interest rate derivatives have become some of the most important derivative instruments, making up a higher proportion of financial market deals. Although financial markets are dominated by stock and stock indices in terms of activity, the bond market, and consequently the interest rate derivatives markets dominate in terms of value. However, most of the bond and interest rate derivatives transaction occur in over-the-counter markets. Additionally, there are well developed exchange markets for interest rate derivatives, such as the Chicago Mercantile Exchange. Noteworthy, is also the fact that interest rate derivatives are an essential ingredient in the management of interest rate risk. This paper highlights a number of such instruments including swaps, caps, collars, and floors. The paper further explores the modelling of interest rates, as well as the significance of interest rates in bond valuation.