Fixed-income securities are investments that provide a regular return. Bonds issued by governments, corporations and banks are examples of this type of security. A fixed-income derivative is a contract whose value derives from the value of a fixed-income security. For instance, a bond future is a derivative priced in accordance with the anticipated price of an underlying bond or bond index. There are two basic types of fixed-income derivatives. The first type, interest-rate derivatives, is based on the direction of interest rates. The second type, credit derivatives, is based on credit risk, or the probability of a bond issuer defaulting on an obligation.
Interest Rate Swaps
An interest rate swap is a fixed-income derivative in which counterparties exchange different cash flows. One cash flow is based on a fixed interest rate applied to a notional, or imaginary, principal amount; the other cash flow is a floating interest rate applied to the same notional amount. The floating rate is tied to a well-known index, such as the U.S. federal funds rate or the London interbank offer rate (LIBOR). As an example, Counterparty A has purchased $100 million in 7 percent notes, but believes interest rates are about to rise. Counterparty B predicts lower interest rates. Counterparty A agrees to pay a fixed 7 percent on $100 million notional to Counterparty B, who in turn agrees to pay Counterparty A the current LIBOR rate on the $100 million notional amount.
Bond Futures Contract
A bond futures contract is an agreement to buy or sell a bond in the future at a price agreed upon now. Futures contracts are standardized instruments traded on futures exchanges. Treasury bond futures are traded on the Chicago Mercantile Exchange. The contract call is based on underlying Treasury bonds of between 15 and 25 years maturity. The price of the futures contract is theoretically determined by the anticipated future price of the underlying bonds discounted at the risk-free (Treasury bill) rate. Actual contract prices are determined by supply and demand on the exchange floor. Bond forward contracts are similar to bond futures, except the contracts are not standardized and do not trade on an exchange -- they are termed over-the-counter securities.
Credit Default Swaps (CDs)
Credit default swaps (CDs) are credit derivatives that protect a buyer against the occurrence of a credit event on an underlying bond position. A credit event is any reduction of the creditworthiness of a bond. Examples of credit events include ratings downgrades, bankruptcies and corporate restructurings. The protection buyer, who need not own the underlying bonds, pays a quarterly premium to the protection seller. A CDs, although similar to an insurance policy, is not subject to federal or state insurance regulations.
Bond and Bond Futures Options
A bond option is the right, but not obligation, to buy (via a call) or sell (via a put) a specified face value of bonds at an agreed price (the strike price) on or before the option expiration date (in the case of American-style options) or only on the expiration date (for European-style options). The option buyer pays a one-time premium to the option seller for this right. Bond options are traded over-the-counter and are priced using a mathematical formula such as the Black model. The model uses the future anticipated, or forward, price of the underlying bond as one of its inputs. A related derivative is an exchange-traded bond futures option, in which the underlying security is a futures contract on a bond, such as a Treasury bond future, rather than the bond itself.