Fixed Income Securities: Valuation, Risk, and Risk Management

CHAPTER 5

INTEREST RATE DERIVATIVES: FORWARDS AND SWAPS

Interest rate “derivatives” play a central role in modern financial markets. The quotation marks around the word “derivatives” is almost mandatory nowadays. Traditionally, we think of a derivative security as a security whose value depends on the value of some other more basic security. That is, the value of the derivative security “derives” from the one of a primitive security. That’s the traditional view, which was fine at the time in which basic derivative securities, such as forwards, futures, and swaps, were introduced in the 1970s and 1980s. Nowadays, however, the market size of interest rate derivatives is much larger than the market of the primary securities. For instance, in this chapter we learn how to compute the value of swap contracts from discount factors, possibly obtained from the prices of Treasury securities, as discussed in Chapter 2. However, as we do so, we must keep in mind that while as of December 2008 the market size of U.S. Treasury securities was around $5.9 trillion, the global market value of swaps was about $16 trillion. The obvious question is then whether the value of swaps depends on the value of Treasuries, or vice versa. Here we are in a “chicken-and-egg” situation, because we cannot be sure anymore which one is the primary market and which are the “derivative markets.” In this chapter we learn that some relations – no arbitrage relations – must exist between the values of the securities. ...