CONTRACT TERMINOLOGY AND SPECIFICATIONS OF DERIVATIVES

SHOBIKA B Definition:

▪ The instrument in which the underlying asset has the right to pay or receive money at a given rate of interest. In simple words, it is a based on an underlying, the value of which is impacted by any change in the interest rates. Types of Interest rate derivatives: ▪ Vanilla ▪ Quasi Vanilla ▪ Exotic derivatives Examples of types of interest rate derivatives: :

▪ It gives a buyer the to purchase interest rate agreement at a given time. The buyer pays for the right to purchase but is not obligated to do the same. Interest rate swaps (IRS):

▪ It is an agreement to exchange series of fixed cash flows with floating cash flows. Each participating party agrees to pay a fixed or floating rate in a particular currency. These are used to convert liability or investment from fixed to floating and vice versa. Initially valued at zero, then the IRS are valued as the difference between fixed rate and floating rate of the . Interest rate future:

▪ It is defined as the contract between buyer and seller agreeing to future delivery of any interest bearing underlying asset. Forward rate option:

▪ It is a financial contract between two parties to exchange interest payments based on a notional principal for a specified future period. It is used by the corporates to their future loan exposure against rising rates. Interbank participants use it for speculative purposes. Interest rate cap / floor:

▪ It is designed to provide protection against upward interest rate movements by putting a ceiling on the movements. On the other hand, interest rate floor, protects the holder from adverse downward movement in the interest rates. Cross currency swaption:

▪ It is an agreement between two parties to exchange interest payments and principal on loans denominated in two different currencies. These are used to convert the liability/investment in one currency to another currency. The valuation is similar to IRS. Three types of transactions in the futures market: ▪ Speculation ▪ ▪ Hedging Advantages of Interest rate derivatives: ▪ Interest rate derivatives are opted for adjustments of portfolios ▪ They are more liquid compared to the underlying instrument ▪ They help in lowering the cost of funding ▪ Speculative positions can be taken in context to future movement in interest rates ▪ They can provide yield irrespective of the market conditions Disadvantages of Interest rate derivatives: ▪ Risk of loss is unlimited ▪ Prices are generally not available publicly ▪ Complex structure of the derivative can make it difficult to gauge the risk and calculate the yield