CHAPTER 4Cash Bonds and Futures
Amir Sadr
In order to price and manage the risk of any fixed‐income product including bonds, swaps, and interest rate derivatives, one requires a basic knowledge of discounting, interest rates, and sensitivity measures such as duration.
TOOLS OF THE TRADE
Consider a 1‐year loan of $100 at an interest rate 
. In 1 year's time, the lender will receive the original amount lent, $100, and the interest of 
, for a total of $104. The interest payment is in compensation for use of the money, i.e., the lender could have used the $100 for other purposes, maybe a lucrative investment, and hence needs to get compensated for this opportunity cost.
Now, consider a 2‐year loan at the same annual interest rate of 
. The 1‐year future value of it is $104, and the 2‐year future value is 
. The $8 is the interest for 2 years, $4 per annum, and the extra 
is due to compounding effect: receiving interest on interest.
One can enter into loans with a stated annual interest rate, ...
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