Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Over-the-Counter Interest Rate Derivatives

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Over-the-Counter Interest Rate Derivatives

Article excerpt

Over-the-counter (OTC) interest rate derivatives include instruments such as forward rate agreements (FRAs), interest rate swaps, caps, floors, and collars. Broadly defined, a derivative instrument is a formal agreement between two parties specifying the exchange of cash payments based on changes in the price of a specified underlying item or differences in the returns to different securities. Like exchange-traded interest rate derivatives such as interest rate futures and futures options, OTC interest rate derivatives set terms for the exchange of cash payments based on changes in market interest rates. An FRA is a forward contract that sets terms for the exchange of cash payments based on changes in the London Interbank Offered Rate (LIBOR); interest rate swaps provide for the exchange of payments based on differences between two different interest rates; and interest rate caps, floors, and collars are option-like agreements that require one party to make payments to the other when a stipulated interest rate, most often a specified maturity of LIBOR, moves outside of some predetermined range.

The over-the-counter market differs from futures markets in a number of important respects. Whereas futures and futures options are standardized agreements that trade on organized exchanges, the over-the-counter market is an informal market consisting of dealers, or market makers, who trade price information and negotiate transactions over electronic communications networks. Although a great deal of contract standardization exists in the over-the-counter market, dealers active in this market custom-tailor agreements to meet the specific needs of their customers. And unlike futures markets, where futures exchange clearinghouses guarantee contract performance through a system of margin requirements combined with the daily settlement of gains or losses, counterparties to OTC derivative agreements must bear some default or credit risk.

The rapid growth and energized pace of innovation in the market for interest rate derivatives since 1981, the date of the first widely publicized swap agreement, has proven truly phenomenal. The advent of trading in interest rate swaps was soon followed by FRAs, caps, floors, collars, as well as other hybrid instruments such as forward swaps, options on swaps (swaptions), and even options on options (captions).

This article offers an introduction to OTC interest rate derivatives. The first five sections describe some of the most common types of OTC derivatives: FRAs, interest rate swaps, caps, floors, and collars. The final section discusses policy and regulatory concerns prompted by the growth of the OTC derivatives market.

1. FORWARD RATE AGREEMENTS

FRAs are cash-settled forward contracts on interest rates traded among major international banks active in the Eurodollar market. An FRA can be viewed as the OTC equivalent of a Eurodollar futures contract. Most FRAs trade for maturities corresponding to standard Eurodollar time deposit maturities, although nonstandard maturities are sometimes traded (Grabbe 1991, Chap. 13). Trading in FRAs began in 1983 (Norfield 1992).

Banks use FRAs to fix interest costs on anticipated future deposits or interest revenues on variable-rate loans indexed to LIBOR. A bank that sells an FRA agrees to pay the buyer the increased interest cost on some "notional" principal amount if some specified maturity of LIBOR is above a stipulated "forward rate" on the contract maturity or settlement date. The principal amount of the agreement is termed "notional" because, while it determines the amount of the payment, actual exchange of the principal never takes place. Conversely, the buyer agrees to pay the seller any decrease in interest cost if market interest rates fall below the forward rate. Thus, buying an FRA is comparable to selling, or going short, a Eurodollar or LIBOR futures contract.

The following example illustrates the mechanics of a transaction involving an FRA. …

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