Use of Derivatives for Interest Rate Risk Management
Interest Rate Caps
This derivative instrument protects its holder against rising market interest rates in return for paying an upfront premium. Borrowers are assured that institutions lending them money cannot increase their loan rate above the level of the cap. The bank may alternatively purchase an interest rate cap from a third party (say from a financial institution), which promises to reimburse borrowers for any additional interest they owe their creditors beyond the cap. Banks buy interest rate caps when conditions arise that could generate losses, such as when a bank finds itself funding fixed rate assets with floating rate liabilities, possesses longer term assets than liabilities, or perhaps holds a large portfolio of bonds that will drop in value when interest rates rise.
Also read about :
Interest Rate Floors
Interest Rate Collars