APPENDIX ADeriving the Rule of Thumb

The rule of thumb for calculating the rate of drift in Eurodollar rates relative to forward rates stems directly from calculating the expected gain when a forward swap is hedged with Eurodollar futures and applying the “no free lunch” principle.

SWAP VALUE

The net present value of a forward swap that receives fixed and pays floating for a 3-month period is:

image

where

NPA is the swap’s notional principal amountX is the fixed rate at which the swap is struckF is the forward rate

Days is the actual number of days in the swap period to which the floating and fixed rates apply

Z is the fractional price of a zero-coupon ...

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