Introduction to Structured Finance

CHAPTER 2

Interest Rate Derivatives

As we explained in Chapter 1, structured finance products are often linked to derivative instruments. As the name implies, a derivative instrument is one that derives its value from the value of some underlying variable or variables. Derivative instruments take the form of futures contracts, forward contracts, swap agreements, and option-type contracts. Derivative instruments are classified based on their underlying. They include interest rate derivatives, currency derivatives, equity derivatives, commodity derivatives, and credit derivatives. In this chapter and the one to follow, we will focus on two commonly used derivatives, interest rate derivatives (the subject of this chapter) and credit derivatives (the subject of Chapter 3). The forms of derivatives (futures/forwards, options, swaps) for currency, equity, and commodity derivatives are similar to those described for interest rate derivatives.

INTEREST RATE FORWARD AND FUTURES CONTRACTS

A forward contract is an over-the-counter agreement between two parties for the future delivery of the underlying at a specified price at the end of a designated time period. The designated date at which the parties must transact is called the settlement or delivery date. The party that assumes the long (short) position is obligated to buy (sell) the underlying at the specified price. The terms of the contract are the product of negotiation between the two parties. As such, a forward contract is specific ...