Interest Rate Derivatives Flashcards
interest rates
the rate at which the lender requires the borrower to pay for the use of money
treasury rates
rates on instruments issued by a government in its own currency
risk free rates
short-term interest rates offered by highly credible governments or institutions
LIBOR (London Interbank Offering Rates)
rate of interest at which a bank is prepared to deposit money with another bank
LIBOR alternatives SONIA (sterling overnight index average)
in the uk or secured overnight financing rate (SOFR) in the US
measurement of interest rates
the compounding frequency used for an interest rate is the unit of measurement
continuous compounding
the limit as we compound more and more frequently we obtain continuously compounded interest rates
zero rates
for maturity T is the rate of interest earned on an investment that provides payoff only at time T
yield curve
graphical derivation of the relationship between the yield of bonds of the same credit quality but different maturities
forward rate agreements (FRA)
financial contracts that allow counterparties to lock in a forward interest rate, the buyer of an FRA contract locks in a fixed borrowing rate and seller a fixed lending rate
- cash settlement will involve the difference between the FRA rate and reference rate (usually LIBOR)
- the buyer profits from increasing interest rates, the seller benefits from diminishing rates
interest rate futures
- like any other OTC instruments, FRA is a bespoke contract and is subject to counterparties abilities to fulfil their obligations
- thus is depends on credit worthiness of the counterparty
- access is only available to big players
- limited oversight and regulations from the regulators
- closing out from the FRA is not easy
- interest rate futures are an exchange traded contracts to overcome difficulty with forwards
