Swaps, Futures, and Linear Rate Derivatives: Overview

The vast majority of interest-rate derivative activity — by notional — involves linear instruments: instruments whose value changes approximately linearly with the interest rate. Repo agreements, forward rate agreements, interest rate futures, and interest rate swaps all fall into this category. Unlike options, they carry no optionality premium and are priced purely from the forward curve and discount factors. Yet they are far from trivial: futures embed a daily mark-to-market that creates a convexity adjustment relative to the equivalent forward; bond futures allow the short party to choose which bond to deliver (the "quality option"); and the interest-rate swap market, with over $400 trillion in notional outstanding, is the largest single derivatives market in the world.