What are Fixed Income Derivatives?
Fixed income derivatives are financial investments that have a value deriving from another assets. Strictly speaking, the income amount from those investments is not always fixed. Instead, it can vary with interest rates or inflation, and carries a risk of default. Common fixed income derivatives include credit default swaps and interest rate swaps.
The name fixed income derivatives can easily cause confusion. To understand it, it's necessary to appreciate two points about the concept. The first is that the derivative itself does not necessarily have a fixed income. Instead, the derivative is based on a fixed income asset. The people involved in the derivative do not have any direct interest in the fixed income asset; rather, they exchange money based on the value of that asset. One way to comprehend this is to liken the arrangement to a wager on a sports game: the gamblers have no involvement in the game or the final score, but do exchange money based on the score.
The other confusion comes with the nature of the fixed income assets. This does not necessarily mean the amount of payment is either fixed or guaranteed. Instead, it means that the holder of the asset receives a regular payment, rather than only making money by selling the asset at a profit. This payment amount could vary, for example with an inflation-linked bond. Investors considering the value of a fixed income asset and associated derivatives must also take into account the risk that the issuer will default on making payments.
There are two main forms of fixed income derivatives. The first is an interest rate derivative, which is where the payments between the two parties in the agreement are related to some form of interest rate. The simplest example is an interest rate swap, which involves both parties agreeing to pay the other a hypothetical interest payment on a hypothetical loan amount. While one party pays on an interest rate fixed when the deal is made, the other party pays based on the actual market interest rate on the agreed payment date. In effect, therefore, the two sides are making a wager about future interest rate movements.
The other main class of fixed income derivatives is credit derivatives. In effect, this is an agreement between two investors who make a wager about whether a particular borrower will default on a particular loan or other credit agreement. Originally, this type of deal involved the lender taking out a derivative that would pay out if the borrower didn't repay, effectively making it an insurance policy. As of 2011, the market for credit derivatives has grown such that the two parties involved may have no connection to the loan or credit agreement itself.
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