What a Derivative Is

1.1Derivatives in one paragraph

A derivative is a contract whose payments are worked out from a number neither party controls, such as an interest rate. This workbook follows one company's interest-rate hedge from the first proposal to the day it ends. You are a junior solicitor at Blackwood & Steel LLP in London, and you act for the company.

1.2Why companies hedge a floating-rate loan

Most company loans carry a floating rate. The banks add a fixed margin to a published market rate, which is reset every few months. Many companies then fix that cost with a separate contract:

• A fixed cost is easier to budget for and to explain to investors.
• A higher interest bill can break a promise in the loan, and that is a default.
• Lending banks usually lend only at a floating rate, so a borrower buys certainty separately.

1.3The deal in this workbook

The company is Atlas Payments Group plc, a payments group listed in London. In July 2026 it agreed to buy an Irish crypto-asset firm, Solaris. To pay for it, Atlas signed a Facility Agreement (“the FA”) with three banks led by Pellhaven Bank plc.

The FA gives Atlas Facility A, a €35,000,000 term loan. Atlas draws it once, when the purchase completes, and repays it in one sum on 14 July 2031. Each quarter it is priced at EURIBOR plus a Margin of 3%. A smaller revolving credit facility (RCF), Facility B, is never hedged and stays out of this workbook.

EURIBOR is a euro interest rate published each business day in Brussels, for several periods. Facility A uses the three-month rate. Atlas has no say in it, and under the FA it never counts as less than zero.

1.4What Atlas is exposed to

Atlas owes €35,000,000 whatever EURIBOR does. Its exposure is not the principal but the interest on it, which rises and falls with EURIBOR.

Nobody at Atlas chooses the row, and the covenant in clause 17 of the FA shows why that matters. It sets a test called Interest Cover: Atlas's earnings must be at least four times its interest bill. The test is run at the end of every June and December, first in December 2026.

Earnings do not rise when EURIBOR rises. So on the bottom row the same earnings must cover twice the bill of the top row. That is how “rates went up” becomes “Atlas is in default under clause 17”.

1.5The two figures in every derivative

Every derivative is built from two figures. The underlying is the number neither party controls, which here is 3-month EURIBOR, the loan's own rate. The notional is the amount that number is applied to. On agreed dates the parties pay each other sums worked out from the two.

The contract Atlas will sign with Pellhaven defines both:

“Neither party controls” lets both sides check every payment against the same public screen. “Never lent, paid or owed” is the phrase boards mishear. Atlas does not need to move €35,000,000 to change the interest on it.

1.6The four families of derivative

There are four families of derivative: forwards, futures, swaps and options. Two questions separate most of them. Does it pay on one date or on many? And can both parties end up owing, or only one?

A forward fixes a price today for one later date. When the day comes, the party on the wrong side of that price pays the difference. A future is the same promise in a standard size, traded on an exchange. Atlas will trade no futures, because its loan has its own amount and its own dates.

A swap repeats the forward's promise on many dates over years. Each party owes a stream of payments on the same notional, and on each date the two are netted into one payment. Atlas will trade the classic kind: it pays a fixed rate and receives the floating one.

An option is one-way. The buyer pays a fee once, called the premium, and after that it only receives. On an interest rate, a cap pays the buyer when the rate is above an agreed level, and a floor pays when it is below one. Atlas will buy a cap.

A collar is a cap bought and a floor sold together. It costs less, because the sold floor pays for part of the cap. But the sold floor is a promise by the buyer, so the buyer can owe again.

All of Atlas's trades are over the counter: private contracts with one named bank, on Atlas's own amounts and dates. No exchange stands in the middle, so Atlas relies on the bank's own promise.

1.7What a hedge does, and what it does not do

A hedge is a second contract whose payments move the opposite way to the first. Atlas's loan costs more when EURIBOR rises, so Atlas wants a contract that pays it more when EURIBOR rises. Laid over the loan, the total cost then stands still.

With a swap, the cost stops moving, but it does not get smaller. When EURIBOR is high, the bank pays Atlas, and that payment meets the loan's extra interest. When EURIBOR is low, Atlas pays the bank, so the cheap quarter goes back to the bank. A swap stops the cost moving either way: Atlas gives up the falls in return for protection from rises.

Keeping the falls while capping the rises is what an option sells. That is why a cap costs a premium and a swap costs nothing at the start.

A hedge works only while it mirrors the loan. Check four things against the FA:

• The notional: never more than the loan, and following its repayments.
• The dates: payments fall on the days the loan's interest is due.
• The benchmark: the same 3-month EURIBOR that the loan uses.
• The floor: if the loan reads EURIBOR below zero as zero, the hedge should too, or the file says why.

Never call the swap “insurance”. Insurance pays for a loss the insured must prove, but a swap pays when a published number moves, whether or not Atlas lost anything.

1.8Why one master agreement holds every trade

A trade is agreed in a few minutes on a recorded phone call: a rate, a notional, done. Nobody can negotiate a full contract that fast, so the market splits the paper in two. Each trade's own rates, amounts and dates go in a short Confirmation. Everything that should hold for every trade goes once into a master agreement, signed before the first trade.

The master agreement holds the promises each side makes, the defaults, and what happens if trading must stop. Its recitals (the opening statements of intent) set out the design:

Recital (C) matters most. Because the master agreement and every Confirmation form one agreement, the trades stand or fall together. If the relationship must end, every trade is valued at once and netted into one sum, owed one way. Both sides want that, the bank most of all, because the party left standing then faces one figure, not a pile of separate claims.

The master agreement is not the loan. They are two separate contracts, even though Pellhaven is party to both. Its loan team lends to Atlas and sends the interest notices, and its markets desk deals the hedge for the bank's own account. Keep the two apart in every note you write.

1.9Why Atlas hedges at all

Atlas's board could have done nothing and budgeted for the bottom row of the table. It could not borrow at a fixed rate, because the banks lend only floating and would not change a signed loan. So on 8 September 2026 it chose to keep the floating loan and fix the rate with a separate contract, and recorded that as policy:

The policy sets a band, not a target. Atlas must hedge at least half of its floating-rate term debt, and never more than all of it. Hedging more than the debt would be a bet on rates, not protection. Each instrument must run for at least three years, so the fix does not end before the risk does.

Only swaps, caps and collars are allowed, and only with relationship banks. A five-year promise is only as good as the bank behind it.

The FA contains no hedging covenant. Atlas hedges because its board decided to, not because a lender asked. So every term of the hedge is Atlas's to negotiate.

Ruth Ellery records the loan and the hedge on a one-page Hedge Sheet. On the day of the board meeting it is mostly blank, because nothing is drawn or hedged yet.

1.10Your job

Your job is to keep the hedge in step with the loan. That is the deal's machinery, because a hedge that drifts from the loan can cost Atlas money for years. Before the first proposal arrives:

• Open the FA at the rate clause and mark EURIBOR, the 3% Margin and the floor at zero.
• Diary the Interest Cover tests in June and December, and 14 July 2031, when Facility A is repaid.
• Get a certified copy of the board minute on the file.
• Note, where the next reader will see it, that the FA contains no hedging covenant.
• Check every new draft of the hedge against the loan, never against the last draft.

Within the week, Henrik Dahl's desk sends two pages of proposed terms: a fixed rate against the floating one, on the loan's own dates. Chapter 2 reads them line by line.