Exposure to the interest rate markets can be hedged with many financial instruments. One of the more flexible is the risk reversal. A key benefit of the risk reversal is that it does not exposure the hedger to immediate gains or losses (similar to a swap or futures contract) as it allows the hedger to create a range in which their exposure is un-hedged.
A futures contract is an obligation between two parties to purchase or sell a physical or financial product as some date in the future. Interest rate futures are traded on exchanges such as the Chicago Mercantile Exchange and provide a clearing platform for traders that eliminate credit risk.
The strategy of a risk reversal for a hedger that is looking to mitigate downside exposure to the interest rate market is to purchase a put on an interest rate futures contract and simultaneously sell a call on an interest rate futures contract. The strike price of the call and the put are generally a certain percentage away from the current spot price, creating a range above and below the current price where the trader is not hedged. If the price of the futures contract falls below the put, the trader receives a payout. If the price of the futures contract rises above the call, the trader needs to make a payment.