Fixed income derivatives are investments for which fixed payments are received in periodic installments until the principal amount is paid out at maturity. Payments under this investment type are known in advance unlike in variable-income securities where payments change based on certain underlying measures such as short-term interest rates. For example, if a government bond offers 5% as the fixed-rate, then an investment of Rs 1,000 would yield Rs 50 as annual payment until maturity when the investor would receive his principal Rs 1,000 back. These types of assets usually offer lower returns on investment because they guarantee income.
Interest rate derivatives and credit derivatives come under fixed income derivatives. In an interest rate derivative, the underlying asset is the right to pay or receive a notional amount of money at a fixed interest rate. Generally, investors with customized cash flow needs or certain views on the interest rate movements use these OTC-traded financial instruments. The interest rate derivative has the largest derivatives market in the world. Meanwhile, credit derivatives are privately held negotiable bilateral contracts that allow users to manage their exposure to credit risk. They are financial assets like forward contracts, swaps, and options for which the price is driven by the credit risk of private investors or governments.
Inflation derivatives are also often included as fixed income derivatives. These are a sub-class of derivative used by individuals to alleviate the effects of potential high inflation levels. The most common under this type are swaps, in which the cash flows of one party are linked to a price index while those of the counterparty are connected to a conventional fixed or floating cash flow.
Besides these, there is a wide range of fixed income derivative products such as options, credit default swaps, interest rate swaps, inflation swaps, government bond futures, interest rate futures and forward rate agreements.