Common Derivative Products Explained
Please see some of the more common interest rate products explained.
Swaps
When structured to mirror your loan terms, this product exchanges a floating interest payment obligation for a known fixed interest payment obligation.
No up-front premium to synthetically “fix” your rate
“Set it and forget it” mentality
You won’t benefit if rates fall
Continued Borrower obligation - can be prohibitively expensive to exit early
Caps
An option that synthetically ”caps” a floating rate. Caps function like an insurance policy against a rise in rates above the chosen cap rate for the term of the cap.
Unlimited subsidies above capped rate
Borrower benefits from falling rates
Known worst-case scenario
No obligation beyond up-front premium
Up-front premium payment
Corridors
Performs as a cap until the high strike is exceeded, after which, subsidies continue to pay out at the maximum. This targeted protection (vs. unlimited) can be designed to align with a pre-defined risk tolerance while providing cost savings.
Borrower benefits from falling rates
Lower up-front premium due to offsetting cost of the high/sold cap strike
No obligation beyond up-front premium
Up-front premium payment
Subsidies may reach a maximum (the width of the corridor)
Swaptions
You buy the option to enter into a swap at a future date and strike. If strike rate purchased is in the money on the exercise date, seller pays the buyer an amount equal to: Swap Rate - Swaption Strike x hedged amount x time
Can purchase a known worst case
If rates are lower at the swaption exercise date, can exercise lower swap rate
Up-front premium payment
Option may expire without value if rates are lower (but Borrower still ”wins”)
