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Interest rate derivatives are financial contracts with underlying assets. They offer the potential either to reduce exposure to economic risk, or increase risk and offer potentially increased earnings. Interest rate derivatives allow the underlying asset to pay at certain interest rates. The basic structures interest rate derivatives include swaps and forwards contracts.
Interest rate derivatives may be used by financial institutions, large or mid-sized companies, governments and individuals managing assets. This type of derivative may be useful to manage exposure in the markets and to take advantage of moving interest rates. An interest rate derivative carries the potential to change the nature of an underlying exposure and eliminate or enhance interest rate volatility.
Caution should typically be used when trading with derivatives, as taking on too much risk may result in losses. Much of the 2008 global financial crisis was blamed on financial losses taken by banks and other financial institutions making large scale, interest rate swaps that ultimately collapsed and caused losses of monumental proportions. Some level of risk is necessary to yield gains in the market, but much risk may be eliminated by placing investments in numerous areas and purchasing interest rate derivatives with caution.
Interest rate swaps are two-party agreements where future interest payments are exchanged based on a principal amount. In an interest rate derivative contract swaps exchange fixed payments for floating payments with interest rates. Companies may use interest rate swaps in their contracts to manage fluctuating interest rates or to obtain lower interest rates.
A derivative containing interest rate swaps may be beneficial to both trading parties. Swaps allow companies seeking fixed interest rate loans to acquire them at lower rates from other companies. Even if the selling company carries a higher floating interest rate than the one they sell, it can still be beneficial to the seller. By trading interest structures, the combined costs for both parties eventually decrease.
Forwards contracts are derivative securities that may be used to hedge risk or profit from an underlying interest rate that may increase in the future. A forward contract is a cash market transaction that delivers commodities after the contract has been made. These contracts allow for buyers to lock in at current prices for commodities that will be sold in the future. This contract is made with the assumption that prices will rise, not fall, over time.