This chapter turns to the analysis of fixed-income derivatives. These are instruments whose value derives from a bond price, interest rate, or other bond market variable. As shown in Table 10.1, fixed-income derivatives account for the largest proportion of the global derivatives markets. Understanding fixed-income derivatives is also important because many fixed-income securities have derivative-like characteristics.
This chapter focuses on the use of fixed-income derivatives, as well as their valuation. Pricing involves finding the fair market value of the contract. For risk management purposes, however, we also need to assess the range of possible movements in contract values. This will be further examined in the chapters on market risk.
This chapter presents the most important interest rate derivatives and discusses fundamentals of pricing. Section 10.1 discusses interest rate forward contracts, also known as forward rate agreements (FRAs). Section 10.2 then turns to the discussion of interest rate futures, covering Eurodollar and Treasury bond futures. Although these products are dollar-based, similar products exist on other capital markets. Interest rate swaps are analyzed in Section 10.3. Swaps are very important instruments due to their widespread use. Finally, interest rate options are covered in Section 10.4, including caps and floors, swaptions, and exchange-traded options.
10.1 FORWARD CONTRACTS
Forward rate agreements (FRAs) are ...