Essay: What is Interest Rates Risk and Derivative

Essay: What is Interest Rates Risk and Derivative
April 12, 2011 Comments Off on Essay: What is Interest Rates Risk and Derivative Academic Papers on Business Studies,Sample Academic Papers admin

Sample Essay

Interest rates risk is the risk which arises because of the movements in the interest rates in the market, particularly relevant to the interest bearing assets like bonds[1]. The relationship between these assets and interest rates is negative which means that as the rate of interest increases, the price of these assets falls[2]. To fix these interest rates fluctuations, companies use financial instruments like interest rates swaps. An interest rate swap is a kind of derivative where one participant exchanges a future stream of interest rate with another stream of cash flows of another party. Contrary to corporate bonds, there is no risk on the principal amount of these securities[3]. These swaps are also used virtually to hedge the profitability of bonds due to the changes in interest rates.

The mechanism of Interest Rates Swaps (IRS) is that each party changes its position on interest rates with some other party[4]. For example, a person is earning some amount of floating interest rate but wants to shift to the fixed interest rate. There is another person out there who wants to get a security which pays fixed interest rate. Both these parties will exchange the securities with each other. First, they will change their cash flow to some international currency like dollar and then exchange at the fixed rate which is called the swap rate[5]. These swaps are now widely used by firms to eliminate their risk to the changing interest rates by swapping their floating interest rate assets with the fixed rate assets. There many kinds of interest rate swaps like floating for fixed rate in same currency and in different currencies and fixed for floating etc[6]. An interest rate derivative is a specific derivative in which the main underlying asset is the right to pay or receive a particular amount of money on a predetermined interest rate. This interest rates derivative market is the largest exchange market in the world with total size of almost $60 billion by the end of 2004. The main international association is the International Swaps and Derivative Association[7]. According to the reports of the organization, there are 80% of the top 500 companies of the world use interest rates derivatives in order to manage their cash flows. Among these derivatives are 75% of foreign exchange options to hedge the currency fluctuations, 25% consist of commodity options used to hedge the commodity rate fluctuations like oil prices and 10% part consist of stock options used to fix the rate of return on stocks, in the year of 2003[8]. The main types of interest rates derivatives are the Interest Rate Swaps, Interest Rates Cap or Floor, Interest Rates Futures and Cross Currency Swaps[9]. An interest rates cap is the form of derivatives where purchaser takes payments at the end of period when the interest rates exceed the agreed strike price. The standard interest rates used in this case as a reference is the London Interbank Offered Rate (LIBOR).

[1] Clark, E. International Finance. London: Thomson, 2002.

[2] Dolde, W. “The trajectory of corporate financial risk-management .” Journal of Applied Corporate Finance, 1993: 33-41.

[3] Subramani, Vijayan, and Ananth Narayan. “Fixed income derivatives for India.” 2009. (accessed 2010).

[4] Wilmott, P. Derivatives. New York: J. Wiley, 1998.

[5]Ludwig, Mary S. Understanding interest rate swaps. New York: Mary S. Ludwig, 1993.

[6] ibid

[7] ISDA. About ISDA. 2009. (accessed 2010).

[8] ibid

[9] Ludwig, Mary S. Understanding interest rate swap, p.154

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