The interest rate swaps market is enormous. The aggregate outstanding no-
tional (or fictitious principal) of over-the-counter (OTC) interest rate swaps
and options stood in excess of $400 trillion by the end of 2010, according to
the Bank for International Settlements. These products are used routinely
by a variety of financial institutions, including banks, insurance companies,
hedge funds, government-sponsored enterprises, and many other corpora-
tions for the purposes of effective risk management and/or expressing a view
on the market.
One of the hallmarks of these markets (and a theme that is emphasized in
this text) is the continued pace of product innovation over the course of time.
The building blocks of these markets are interest rate swaps and interest rate
options (both caps and floors, as well as swaptions). When these products
first came on the scene, they were considered revolutionary. The ability of
corporations to transform the nature of their assets and liabilities from fixed
to floating (or vice versa) and to hedge their exposure to movements in
benchmark interest rates provided a new set of risk management tools.
As these markets developed further, we saw a variety of highly customized
(perhaps better known as exotic) products emerge. These products allowed
financial institutions and other corporations to effectively manage more so-
phisticated risks or, in some cases, to express more tailored views on the mar-
ket than had previously been possible with existing products. And around
the same time, we saw a new wave of financial engineering of these products
enter the scene.