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An overview of the interest rate derivative industry

The interest rate derivative industry is an international multi-billion dollar industry that has experienced exponential growth since the early nineties, in both the number of contracts and the number of users.

An interest rate derivative is a financial instrument used to hedge against interest rate risk, or to speculate on movements in interest rates. There are usually two parties to a contract that involves one party paying a fixed rate of interest and the other a floating rate of interest, on a pre-determined notional amount and schedule. The floating rate is most often linked to some inter-bank offer rate (LIBOR in the United States, Europe and the big Asian markets). The above instruments are traded actively on both physical exchanges and in the OTC-market (Over the Counter market). Physical exchanges include CME (Chicago Mercantile Exchange) and LIFFE (London International Financial Futures and Options Exchange). By far the biggest volume occurs in the OTC market. ISDA (International Swaps and Derivatives Association) provides standardised documentation to the OTC industry. Although the bulk of trade volume occurs in the inter-bank market, the non-inter-bank market still accounts for billions of dollars in daily trade volume. The parties to a contract in the non-inter-bank market usually consist of a bank and a corporate treasury, or a bank and a fund-manager with a mandate to trade in fixed income products and/or interest rate derivatives.

 

The administration of interest rate derivatives

Central to the daily administration of interest rate derivatives, is a highly specialised process of valuing such contracts. This valuation process is a direct input into the accounting for, the risk-management of, and the determination of collateral movements. An interest rate derivatives trader also uses this valuation process to determine relative buying or selling opportunities.

Valuing an interest rate derivative, requires the "bootstrapping" of an interest rate yield curve from available market quotes. As the OTC market is not regulated and not public, compared to equity prices on an exchange, obtaining these quotes can become problematic. ISDAFIX queries leading international banks in seven international markets on a daily basis to obtain average mid market inter-bank quotes. These quotes are published via commercial information channels such as Bloomberg's and Reuters. Bramaan.com processes this information to the point where it becomes useful in the valuation process.

The daily administration also involves the anticipation and processing of scheduled payments, and collateral movements and the creation of appropriate documentation. Big players in the industry usually spend millions of Rands on dedicated departments and software systems to accomplish the above. Smaller players mostly receive this as part of an incentive to trade, or at a fee from specialised service providers. Bramaan.com's business model aims to undercut the pricing of all of the above, through the technological advantage of having custom software, designed from the ground up, for the specific use as a multi-tenant-efficient interest rate derivatives platform, and by focusing only on the essentials in the administration of a limited number of asset-classes, e.g. interest-rate-derivatives.