A firm or an individual faces an interest rate risk when there is a need to borrow or lend money at a future date. Interest rates, both real (net of inflation) and nominal, are volatile. One of the important tasks of financial management is to reduce the exposure of the agent to interest rate risk. If a firm needs to borrow money at a future point in time it can 'hedge' its exposure to an increase in rates in a number of ways. The principal instruments available for the hedging of interest rate risk are: 'forward contracts', which are agreements made now to borrow or lend money in the future at a fixed agreed rate of interest; 'futures contracts', which are standardized forward contracts traded on a futures exchange; and 'option contracts', which give the holder the right to borrow or lend at a fixed rate, but in contrast with forward contracts the holder of the option is not obliged to borrow or lend at the agreed rate if market interest rates change.

Borrowers often require money over longer periods of time (for example, from five years to twenty-five years). To hedge over longer periods borrowers can use an interest rate 'swap contract' or an interest rate 'cap contract'. A swap is a portfolio, or series, of interest rate forward contracts covering successive borrowing periods. Likewise, an interest rate cap is a series of interest rate option contracts. Most interest rate risk management is done through swap and cap contracts.

Many hedging contracts are made between banks and corporate clients on what is known as the over-the-counter market. These contracts are often specially structured to suit the needs of the corporate client. Many are known as 'exotic' or 'complex' derivatives. Examples are diff swaps, binary options, pay-as-you-go options and zero-cost options.