Interest Rates and Related Contracts

Abstract

By a fixed-income market we mean that sector of the global financial market on which various interest rate-sensitive instruments, such as bonds, swaps, swaptions, caps, etc. are traded. In real-world practice, several fixed-income markets operate; as a result, many concepts of interest rates have been developed. There is no doubt that management of interest rate risk, by which we mean the control of changes in value of a stream of future cash flows resulting from changes in interest rates, or more specifically the pricing and hedging of interest rate products, is an important and complex issue. It creates a demand for mathematical models capable of covering all sorts of interest rate risks. Due to the somewhat peculiar way in which fixed-income securities and their derivatives are quoted in existing markets, theoretical term structure models are often easier to formulate and analyse in terms of interest rates which are different from the conventional market rates. In this chapter, we give an overview of various concepts of interest rates. We also describe the most important financial contracts related to interest rates. A more detailed description of real-world bond and swap markets can be found in Fabozzi and Fabozzi (1989) and Das (1994), respectively. Grabbe (1995) focuses on contracts related to international financial markets.