An investment strategy that uses derivatives to hedge an investor's exposure to interest rate fluctuations. The investor purchases an interest rate ceiling for a premium, which is offset by selling an interest rate floor. This strategy protects the investor by capping the maximum interest rate paid at the collar's ceiling, but sacrifices the profitability of interest rate drops. |||An interest rate collar can be an effective way of hedging interest rate risk associated with holding bonds. Since a bond's price falls when interest rates go up, the interest rate cap can guarantee a maximum decline in the bond's value. While interest rate floor does limit the potential appreciation of a bond given a decrease in rates, it provides upfront cash to help pay for the cost of the ceiling. Let's say an investor enters a collar by purchasing a ceiling with a rate of 10% and sells a floor at 8%. Whenever the interest rate is above 10%, the investor will receive a payment from whoever sold the ceiling. If the interest rate drops to 7%, which is under the floor, the investor must now make a payment to the party that bought the floor.
An interest rate derivative in which the holder has the right to receive an interest payment based on a variable interest rate, and then subsequently pays an interest payment based on a fixed interest rate. If the option is exercised, the investor who sells the interest rate call option will make a net payment to the option holder. |||Interest rate call options can be used by an investor wishing to hedge a position in a loan in which interest is paid based on a floating interest rate. By purchasing the interest rate call option, an investor is able to forecast the cash flow that will be paid when the interest payment is due.Interest rate call options can be used in either a periodic or balloon payment situation.
A yield curve derived by using on-the-run treasuries. Because on-the-run treasuries are limited to specific maturities, the yield of maturities that lies between the on-the-run treasuries must be interpolated, which can be accomplished by a number of methodologies, including bootstrapping and regressions. |||Several different types of fixed-income securities trade at yield spreads to the I curve, making it an important benchmark. For example, certain agency CMOs trade at a spread to the I curve at a spot on the curve equal to their weighted average lives. A CMO's weighted average life will most likely lie somewhere within the on-the-run treasuries, which makes the derivation of the I curve necessary.
Corporate debt securities that are designed to allow ease of purchase by individual investors. Internotes reflect the issued debt of the underlying entity which allows retail investors to gain access to bank, corporate or government bonds. Internotes are usually unsecured and have a minimum investment of $1000. |||Internotes carry credit and secondary market risk. They have a starting price, known as par. If $1000 worth of bonds are purchased, at maturity the initial amount is returned with accumulated interest. They are offered for one week starting on Monday and have separate CUSIP numbers based on the specific terms. These terms could include the maturity, call provisions or coupons.
A type of fixed income security with a maturity, or date of principle repayment, that is set to occur in the next 3-10 years. Bonds and other fixed income products tend to be classified by maturity date, as it is the most important variable in the yield calculations. In a standard (or positive) yield curve environment, intermediate-term bonds pay a higher yield for a given credit quality than short-term bonds, but a lower yield compared to long-term (10+ years) bonds. |||In recent years, there has been a steady decline in the issuance of long-term bonds (those maturing in over 10 years). In fact, the 30-year U.S. Treasury bond was discontinued in 2002 as the spread between intermediate-term and long-term bonds reached all-time lows. While the 30-year Treasury was revived in 2006, for many fixed income investors, the 10-year bond became the "new 30 year", and was considered the benchmark rate in many calculations.
A swap transaction meant to capitalize on a yield discrepancy between bond market sectors. |||Opportunities for intermarket spread swaps exist when there are credit quality or feature differences between bonds. For example, if there is a wide credit spread between high credit quality corporate and treasury bonds, and the spread is expected to narrow, investors would swap government securities for corporate securities.
The yield spread between two fixed-income securities in different sectors with the same maturity. |||In the bond market, an intermarket-sector spread could occur between corporate bonds and government bonds with the same maturity.
A situation in which the yield difference between a longer term financial instrument and a shorter term instrument is negative. This is calculated by subtracting the longer term by the shorter term. In effect, the shorter term instrument is yielding a higher rate of return than the longer term instrument. This is in contrast to what is considered a normal market, where longer term instruments should yield higher returns to compensate for time. |||For example, in the bond market, if you had a three-year government bond yielding 5% and a 30-year government bond yielding 3%, the spread between the two yields would be inverted by 2% (3% - 5% = -2%). The reasons behind this situation can vary and can include such things as changes in demand and supply of each instrument and the general economic conditions at the time.
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