An Introduction to Financial Markets

Chapter Four Forward Rate Agreements, Interest Rate Futures, and Vanilla Swaps

In this chapter, we consider a few simple interest rate derivatives, which are the natural counterparts of the forward and futures contracts introduced in Section 1.2.6, when the underlying variable is an interest rate. We will also appreciate a relationship with forward interest rates, introduced in Section 3.7.

In Chapter 3, we have repeatedly used the concept of risk-free rate and have shown how risk-free rates can be estimated from bond prices. However, if we want to trade derivatives whose underlying variable is a risk-free rate, we need a very precise reference rate, on which financial institutions may formally and legally agree, not just an estimate. In Section 4.1, we introduce two such rates, the LIBOR and EURIBOR rates. These are essential rates, as they are the underlying variables of several derivatives, but they cannot be considered risk-free, as the painful experience during the 2008 credit crunch has shown.

Then, we move on to consider three simple families of interest rate derivatives:

1. Forward rate agreements, in Section 4.2
2. Eurodollar futures, in Section 4.3
3. Vanilla interest rate swaps, in Section 4.4

A stylized presentation of simple forward rate agreements and vanilla swaps may rely only on no-arbitrage arguments, without the need for dynamic stochastic models, which are necessary to analyze options. We just use concepts like bond pricing and forward rates, which have been introduced ...