An interest rate derivative is a type of financial contract in which the value is derived from the performance of an underlying interest rate or a debt instrument. These contracts are commonly used by organizations to protect themselves from any adverse impacts that could result from changes in interest rates. This could include shifts in the yield curve or changes in the local/international markets.

Interest rate derivatives have several distinct types, such as futures, options, swaps, swaptions, and FRA’s. By using an interest rate derivative, entities can reduce their risk exposure related to a shift in interest rates, either in their favor or to their detriment.

For example, if a business is expecting to borrow money in the future, they may purchase an interest rate derivative to hedge against a potential rise in interest rates in the future. In this case, since they’re not yet borrowing money, they can effectively lock in today’s interest rate. The derivative will also provide them with the ability to take advantage of any decrease in rates.

Interest rate futures enable entities to secure a future interest rate with a known value on a specified date. This value is derived from the current market rate, is known on the day of the trade, and does not fluctuate. Additionally, the buyer of the contract assumes that there will be no changes in the underlying interest rate, making this a common option for large scale investors.

Interest rate options allow organizations to have the flexibility to either buy or sell an underlying security or other financial instrument. This is usually done during a specified period of time, usually one year, at a predetermined price. This gives the buyer the ability to either speculate on the movements of interest rates, or hedge against the potential rise of rates.

An interest rate swap is a type of derivative contract involved in direct trading between two parties. It involves an agreement in which one party pays an agreed-upon amount of money, called the fixed leg, while the other party receives an amount related to an underlying floating-rate index, called the floating leg.

Swaptions are similar to options but are linked to interest rate swaps, rather than buying and selling a security. The buyer of a swaption has the right, but not the obligation, to enter into an interest rate swap at a predetermined rate and time. Swaptions are typically used in hedging strategies to protect businesses against shifts in interest rates.

Lastly, an FRA, or Forward Rate Agreement, is a contract between two parties who agree to exchange a fixed and a floating interest rate over a certain amount of time. The fixed rate is determined at the time of the agreement, although the floating rate will change with market fluctuation. Unlike other interest rate derivatives, FRAs do not need to be settled upon expiry.

Interest rate derivatives are a powerful tool for investors, businesses and governments to help protect their portfolios from movements in the underlying interest rate. By taking advantage of an interest rate derivative, entities can effectively manage their interest rate risk.