Globalisation has led to the rise of cross-border finance, in which cross-border interest rate derivatives and cross-border bond derivative are using to meet financing requirements. These two are largely generated through the issuance of derivatives, such as interest rate, cross-border repo interest rate swap, fixed interest rate, and cross-border bond interest rate swap. These instruments, however, were not designed for use by individual investors. Their origins can be traced back to the development of insurance markets.
Fixed income market and its derivatives now form a large part of global banking. They serve as liquidity instruments used by banks and financial institutions to meet requirements. Moreover, these instruments provide a means to directly trade in financial assets that may be more difficult to access through more traditional means.
In the US, interest rate swaps in equity are used to meet operational requirements. These instruments are used for hedging purposes, as well as for speculative purposes.
Interest rate swaps are used as derivatives, which are often traded on different exchanges. This makes it easier for the traders to create and manage positions. When an investor buys a position and sells it again to someone else, the trader is said to 'swap' the position.
Fixed income market and its derivatives include fixed rate bonds and interest rate swaps. Thesetwo instruments can be used to generate funds for investing as well as liquidating positions.
Bonds, like other types of investments, are priced based on the prevailing interest rates. For this reason, interest rate swaps are also known as 'time based swaps'.
Fixed rate bonds and interest rate swaps enable a customer to borrow short-term money at a specific interest rate at a specified maturity date. However, the counterparties are unable to observe the change in interest rates because their maturity dates are fixed.
The role of interest rate swaps is to provide a collateralized interest rate on the assets being traded. They also take care of the risk associated with the fluctuations in the overnight interest rates. This is done by creating a bid/ask spread, whereby one party bids up the price of the currency being traded in order to secure the financial product (i.e.
Fixed rate bonds and interest rate swaps can also be used to hedge against the fluctuations in the price of fixed income securities. Fixed rate bonds and fixed rate swaps can be utilized to provide a potential income stream during volatile periods of the stock market.
Another important feature of these instruments is that they can be used to reduce volatility by adjusting the asset price indices. For example, when the price of an asset falls sharply, such an instrument could be used to adjust the price index, thereby reducing volatility and generating returns.
Fixed income markets and their derivatives can also be used for hedging purposes. One can, for example, enter into a hedging contract to allow him to profit if the price of a certain bond changes drastically. If an investor is unable to purchase the collateralized interest rate contract at its fixed maturity date, he would be paid back the amount invested minus the value of the original bond.