Fixed Income Derivatives
Fixed Income Derivatives are financial contracts whose value is based on the price movements of underlying fixed-income securities. These derivatives are used by investors and traders to hedge risk or to speculate on changes in interest rates, inflation, and credit risk. Here are some common types of Fixed Income Derivatives:
- Inflation Swap: An inflation swap is a financial contract in which two parties agree to exchange payments based on a fixed interest rate and the realized inflation rate. Inflation swaps allow investors to hedge against inflation risk and are commonly used by pension funds and insurance companies.
For example, if an investor agrees to pay a fixed rate of 3% on a notional principal of $10 million in exchange for receiving inflation-adjusted payments based on the Consumer Price Index (CPI), and the realized inflation rate is 2%, the investor would receive $200,000 in payments, while paying $300,000 in fixed interest payments.
- Interest Rate Derivatives: Interest rate derivatives are financial contracts whose value is based on the price movements of underlying interest rates. These derivatives are used by investors and traders to hedge against changes in interest rates or to speculate on interest rate movements.
Some common types of interest rate derivatives include interest rate swaps, interest rate options, and interest rate futures.
- Mortgage-Backed Securities: Mortgage-backed securities (MBS) are fixed income securities that represent an ownership interest in a pool of mortgage loans. MBS are created when mortgage loans are bundled together and sold to investors as a security. These securities can be further divided into pass-through securities, collateralized mortgage obligations (CMOs), and stripped mortgage-backed securities.
MBS are popular among investors who seek higher returns than those offered by traditional fixed income securities, but are also willing to assume higher credit and prepayment risks.
- Treasury and Fixed Income: Treasury and fixed income derivatives are financial contracts whose value is based on the price movements of underlying government securities and corporate bonds. These derivatives are used by investors and traders to hedge against changes in interest rates, credit risk, and market volatility.
Some common types of treasury and fixed income derivatives include Treasury bonds, Treasury notes, Treasury bills, and corporate bonds. These derivatives are widely used by banks, insurance companies, and pension funds to manage risk and generate returns.
In summary, fixed income derivatives are important financial instruments that allow investors and traders to manage risk and generate returns. Inflation swaps, interest rate derivatives, mortgage-backed securities, and treasury and fixed income derivatives are some common types of fixed income derivatives that are widely used in the financial markets.