Interest Rate Derivatives

Abstract

Around the time the Bretton Woods exchange rate system was breaking down in global markets, interest rates in many local markets became much less predictable, leaving businesses and investors exposed to far more interest rate risk than they were familiar with. The financial community began looking for ways to hedge and speculate this risk. To address this need to hedge interest rate risk, the futures exchanges in Chicago and London (and other financial centers) began offering interest rate contracts in addition to their historically traded commodity futures. In 1981, IBM and the World Bank entered into the first interest rate swap, soon followed by a foreign exchange swap. As the Black-Scholes model and other options pricing models became generally accepted, options on interest rates became widely traded in deep, liquid markets. Decades later, the interest rate derivatives markets, both exchange traded and over the counter (OTC), have grown into a huge global marketplace (notional amounts in billions of U.S. dollars equivalent). (See Exhibit 10.1.) These so-called plain vanilla interest rate derivatives totaled almost U.S. $355 trillion at the end of 2006, and there are many other interest rate derivatives that the Bank for International Settlements (BIS) does not report statistics on. At first glance, the BIS total appears to be roughly 10 times global gross domestic product. However, some OTC derivatives are double counted (e.g., each side of the same risk may be on the books of two banks; in practice this is difficult to net). A significant percentage of the total (exchange traded plus OTC) is a hedge against other interest rate risk but does not get netted in the statistics just cited. Most important, the numbers shown reflect notional amounts (i.e., the amounts used to as a benchmark for determining the dollar value of interest rate payments). The market value of these instruments is much smaller. Whole books have been written on each type of interest rate derivative, but the next section provides a sampling of the common types of interest rate derivatives you are likely to see on a broker-dealer fixed income trading floor.