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Interest rate derivatives, such as swaps and forward contracts, can help manage exposure to economic risk and take advantage of moving interest rates. However, caution should be exercised as taking on too much risk can result in loss, as seen in the 2008 financial crisis.
Interest rate derivatives are financial contracts with underlying assets. They offer the potential to reduce exposure to economic risk, or increase risk and offer potentially larger returns. Interest rate derivatives allow the underlying asset to pay at certain interest rates. The basic structures of interest rate derivatives include swaps and forward contracts.
Interest rate derivatives can be used by financial institutions, large or medium-sized companies, governments, and individuals who manage assets. This type of derivative can be useful to manage exposure in the markets and take advantage of moving interest rates. An interest rate derivative has the potential to change the nature of an underlying exposure and eliminate or enhance interest rate volatility.
In general, caution should be exercised when trading derivatives, as taking on too much risk can result in loss. Much of the 2008 global financial crisis was blamed on financial losses suffered by banks and other financial institutions that made large-scale interest rate swaps that ultimately collapsed, causing losses of monumental proportions. A certain level of risk is necessary to profit in the market, but much risk can be eliminated by placing investments in numerous areas and buying interest rate derivatives with caution.
Interest rate swaps are two-way agreements in which future interest payments are exchanged based on a principal amount. In an interest rate derivative contract, swaps exchange fixed payments for floating interest rate payments. Companies may use interest rate swaps in their contracts to manage fluctuating interest rates or obtain lower interest rates.
A derivative containing interest rate swaps can be beneficial to both trading parties. Swaps allow companies seeking fixed-rate loans to purchase them at lower rates from other companies. Even if the selling company has a higher floating interest rate than the one you are selling, it may still be beneficial to the seller. By negotiating interest structures, the combined costs for both parties eventually decrease.
Forward contracts are derivative securities that can be used to hedge risks or benefit from an underlying interest rate that may increase in the future. A forward contract is a cash market transaction that delivers products after the contract has been made. These contracts allow buyers to set current prices for products that will be sold in the future. This contract is made assuming that prices will rise, not fall, over time.
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