(b) identify the main types of interest rate derivatives used to hedge interest rate risks and explain how they are used in hedging. The depositor fears that interest rates will fall, as this will reduce income. Now let`s expect interest rates to rise, with the LIBOR rate rising to 5.25% by the end of the first year of the interest rate swap deal. Further suppose that the swap agreement stipulates that interest payments are made annually (so it is time for each company to receive its interest payment) and that the variable interest rate for Company B is calculated using the LIBOR interest rate in effect at the time the interest payments are due. The interest rate derivatives that are discussed are: Let`s see exactly what an interest rate swap agreement might look like and how it actually works. If interest rates fall, the price of the futures contract will go up, say to 97. Obviously, the borrower would not buy at age 97 and then exercise the put option at age 95, so the option could expire and the company would simply benefit from the lower interest rate. In the case of an interest rate swap, only interest payments are actually exchanged. An interest rate swap, as already mentioned, is a derivative contract. The parties do not assume the fault of the other party.
Instead, they simply make a contract to pay each other the difference in the loan payments specified in the contract. They do not exchange debt securities and do not pay the full amount of interest due on each interest payment date – only the difference due under the swap agreement. Similar to other types of swaps, interest rate swaps are not traded on public exchangesThe exchange refers to public markets that exist for the issuance, purchase and sale of shares traded on or off an exchange. Shares, also known as shares, represent partial ownership of a company – only extra-traded trading mechanisms refer to the different methods used to trade assets. The two main types of trading mechanisms are price-based trading and order-based (OTC) trading mechanisms. In practice, forward price movements do not move perfectly with interest rates, so there are some imperfections in the mechanism. This is called basic risk. A swap can also involve exchanging one type of variable interest rate for another, called a base swap. Generally, in an interest rate swap, both parties negotiate a fixed and variable interest rate.