Interest Rate Derivatives: Features, Valuation and Benefits

Hedging with Interest Rate and Credit Derivatives by Banks

Usually, firms use interest rate derivatives to hedge interest rate risk. Similarly, some non-financial firms in Pakistan are also engaged in the use of interest rate derivatives to hedge their exposure to interest rate risk. Purpose: The purpose of this study is to identify determinants of interest rate derivatives used by non-financial firms in Pakistan and to identify any differences between non-financial firms using interest rate derivatives and non-interest rate derivatives. Methodology: Since interest rate derivatives are taken as dependent binary variables, binary digits 1 and 0 are assigned to firm and non-user interest rate derivatives. As a result, the Logit model is used to identify the determinants of interest rate derivative use. Besides, users and non-users of interest rate derivatives are two groups independent of each, and therefore the Mann Whitney U test is used to identify the difference between them. Results: In line with the literature, the non-parametric Mann Whitney U test resulted in significant differences between interest rate derivative users and non-users. While using the Logit model, there was a significant positive relationship between financial distress costs, asset growth, cash flow, firm size, and interest rate derivatives use. However, there was a negative relationship between profitability (ROA) and interest rate derivatives. Limitation: Since most financial firms use derivatives for trading rather than hedge purposes, the scope of the study is limited to non-financial firms that use derivatives for hedge purposes. Also, the study was launched in 2013-14, so the data collected and used for the period 2006-12 will be used. Implication: The findings suggest that large, financially distressed firms can hedge their interest rate risk and benefit from the optimal utilization of interest rate derivatives. Originality: The study was the first attempt to explore interest rate derivatives in non-financial firms in Pakistan and pave the way for further exploration of the subject matter. Besides, the original data were extracted from the annual reports of the sampled firms.

Around the time the Bretton Woods exchange rate system was breaking down in global markets, interest rates in many local markets became much less predictable, leaving businesses and investors exposed to far more interest rate risk than they were familiar with. The financial community began looking for ways to hedge and speculate this risk. To address this need to hedge interest rate risk, the futures exchanges in Chicago and London (and other financial centers) began offering interest rate contracts in addition to their historically traded commodity futures. In 1981, IBM and the World Bank entered into the first interest rate swap, soon followed by a foreign exchange swap. As the Black-Scholes model and other options pricing models became generally accepted, options on interest rates became widely traded in deep, liquid markets. Decades later, the interest rate derivatives markets, both exchange traded and over the counter (OTC), have grown into a huge global marketplace (notional amounts in billions of U.S. dollars equivalent). (See Exhibit 10.1.) These so-called plain vanilla interest rate derivatives totaled almost U.S. $355 trillion at the end of 2006, and there are many other interest rate derivatives that the Bank for International Settlements (BIS) does not report statistics on. At first glance, the BIS total appears to be roughly 10 times global gross domestic product. However, some OTC derivatives are double counted (e.g., each side of the same risk may be on the books of two banks; in practice this is difficult to net). A significant percentage of the total (exchange traded plus OTC) is a hedge against other interest rate risk but does not get netted in the statistics just cited. Most important, the numbers shown reflect notional amounts (i.e., the amounts used to as a benchmark for determining the dollar value of interest rate payments). The market value of these instruments is much smaller. Whole books have been written on each type of interest rate derivative, but the next section provides a sampling of the common types of interest rate derivatives you are likely to see on a broker-dealer fixed income trading floor.

Dynamic term structure models explain the yield curve variation well but perform poorly in pricing and hedging interest rate options. Most existing option pricing practices take the yield curve as given, thus having little to say about the fair valuation of the underlying interest rates. This paper proposes an m + n model structure that bridges the gap in the literature by successfully pricing both interest rates and interest rate options. The first m factors capture the yield curve variation, whereas the latter n factors capture the interest rate options movements that cannot be effectively identified from the yield curve. We propose a sequential estimation procedure that identifies the m yield curve factors from the LIBOR and swap rates in the first step and the n options factors from interest rate caps in the second step. The three yield curve factors explain over 99% of the variation in the yield curve but account for less than 50% of the implied volatility variation for the caps. Incorporating three additional options factors improves the explained variation in implied volatilities to over 99%.

EMPIRICAL STUDIES ON INTEREST RATE DERIVATIVES by Xudong Sun Dr. Hongtao Yang, Examination Committee Chair Associate Professor of Mathematics University of Nevada, Las Vegas, USA Interest rate models are the building blocks of nancial market and the interest rate derivatives market is the largest derivatives market in the world. In this dissertation, we shall focus on numerical pricing of interest rate derivatives, estimating model parameters by Kalman lter, and studying various models empirically. We shall propose a frontxing nite element method to price the American put option under the quadratic term structure framework and compare it with a trinomial tree method and common nite element method. Numerical test results show the superiority of our frontxing nite element method in the aspects of computing the option and free boundary simultaneously with high accuracy. We shall also employ the Kalman lter and its variant techniques to estimate parameters of the a ne term structure models as well as quadratic term structure models. Various comparisons of di erent Kalman lter performance and both the in-sample t and out-sample t for Monte Carlo simulations as well as real treasury yield data are presented. In addition, we shall propose a general one-factor interest rate model and apply a homotopy perturbation method to valuate bond prices. One of the attractive qualities of the approximated solution of homotopy perturbation method is its fast speed of achieving the same accuracy compared to the tree method.

This paper examines banks’ interest rate risk management and its effects on the persistence and valuation of earnings. We first develop a novel measure of interest rate risk management by incorporating asymmetric changes in interest rates on assets and liabilities in response to market rate changes. Utilising this measure, we document that U.S. bank holding companies with more effective interest rate risk management have more persistent net interest income and a higher valuation of net interest income. This study helps investors and regulators assess banks’ interest rate risk management from the earnings perspective and the sustainability of net interest income.

Interest Rate Risk Management by Indian Scheduled Commercial Banks: Evidence Using Linear Programming Problem and Panel Data Analysis

There are many examples of interest rate derivatives that are actively traded in over-the counter markets and in organized exchanges. Caps, floors, Treasury bond options, Treasury bond futures options, Eurodollar futures options, and swaptions are just some examples of this important class of derivatives in financial markets. They are classified as “interest rate derivatives” because their stochastic movements are directly related to the interest rate movements in a way that is analogous to the stock option price that moves in step with the underlying stock price.

Out-of-Sample Performance of Spot Interest Rate Models

With China’s financial system reform deepening, interest rate liberalization reform has sharply entered an accelerating course. This paper focuses on the interest rate risk of China’s commercial banks in the process of interest rate liberalization. Based on the literature review on interest rate risk management of commercial banks, this paper carries out an empirical analysis on four forms of interest rate risk under the certain background of China, repricing risk, basis risk, optional risk and yield curve risk. Based on the Interest Rate Sensitive Gap Approach and Duration Model, this paper carries out an empirical measurement of interest rate risk of China’s commercial banks in the process of interest rate liberalization. In the end, this paper proposes the countermeasures and suggestions for the interest rate risk management practice of China’s commercial banks.

This chapter is devoted to interest rate derivatives. Interest rate derivatives are financial products derived from interest rates. There are various interest rates that will be mentioned in this chapter. Here we first give the meaning of each interest rate and derive some relations among them.

In this paper, we examine the impact of interest rate risk factors on the interest rate derivatives (IRD) usage by commercial banks in India. We focus our analysis during the period 2008-2010. We have taken this period to highlight that during and after global financial crisis, what were the main factors that influence the interest rate derivatives usage by Indian commercial banks. We have used simulation analysis and regression analysis to identify the interest rate risk factors. Using Tobit fixed effect analysis, we are able to provide empirical evidence that interest rate risk drives the derivatives usages by Indian commercial banks. Our results indicate that asset size, the impact of interest rate shock on equity capital are positively related to use of derivatives for hedging as well as trading and interest rate sensitivity factor is negatively related to the use of derivatives for hedging and trading. New generation private banks have relatively large exposure to derivatives for trading purpose.

In modern conditions of the rapid industrial development the banks have to forecast their risks and profitability precisely, to apply information technologies to assess their activities. To evaluate the bank's income, it is necessary to carry out an internal analysis of its assets and liabilities and determine the factors effecting the bank's profitability by managing interest rate risk. The hypothesis of the study is the analysis of the impact on the net interest income and interest rate risk of a commercial bank of factors such as the exchange rate and the key rate of the Bank of Russia (for example, Sberbank, PJSC). There has been studied the impact of the factors (exchange rate and key interest rate of Central Bank of Russia) on the bank's net interest income by using correlation and regression analysis and building a regression model. Many tools are found to be used by the experienced analysts. One of the main tools is GAP analysis of interest rate risk. There have been illustrated the graphs of changes in interest rates of savings and loan associations during the crisis in the United States in the 1950-1960, of realization of interest rate risk with an increase in interest rates, the distribution of assets and liabilities according to the maturity of the balance sheet structure, the impact of changes in the interest rate GAP on net interest income, etc. A matrix of correlations of all variables in the sample (rates of growing values) was constructed. Conclusions are drawn on the need to use hedging instruments (interest rate swaps, interest rate options), as well as of attracting the most reliable data on the state of interest rate risk in the commercial banks.

Sweeping changes in financial regulation have occurred throughout much of the world following the global credit crisis that began in 2007. Shifts in the regulatory paradigm governing derivatives have been especially dramatic and have already altered the landscape for interest rate derivatives and participants in interest rate derivatives activity. This chapter reviews the products that comprise the global interest rate derivatives market, recent market activity across different products, currencies, and market structures (i.e., exchange-traded interest rate derivatives, non-cleared swaps, and cleared swaps), and the new regulations governing interest rate derivatives in the United States and Europe. The chapter also documents the bifurcation in liquidity for certain non-dollar swaps (especially EUR-denominated swaps) that has arisen as a result of regulatory uncertainties involving the disparate international implementation of recent regulatory changes. A detailed Appendix presents a self-contained overview of the new regulatory framework itself.

Interest Rate Derivatives and Firm Value: Evidence from Mandatory Versus Voluntary Hedging