Abstract
The topic of this chapter is pricing and risk management of derivatives that depend on interest rates. These products can be divided into two classes. The first class consists of derivatives that only depend on interest rates and no other asset classes. An example is given by an option paying the positive part of the difference between an interest rate and a fixed rate. Regarding the second product type, observe that derivatives on other asset classes such as equity, commodities and FX contain discount factors from the payment dates. This introduces an interest rate component into the pricing. As we see in this chapter, the impact of the interest rate volatility is usually much smaller than the contribution from the volatility of the main underlying in the contract. It is therefore often possible to assume deterministic interest rates without too much loss of accuracy. The exceptions are typically for long-dated products where a stochastic model for interest rates is necessary for a proper pricing and risk management. In this second class of derivatives we also include interest rate hybrids for which the dependence on interest rate is explicit, e.g. convertible bonds.
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Ekstrand, C. (2011). Interest Rates. In: Financial Derivatives Modeling. Springer, Berlin, Heidelberg. https://doi.org/10.1007/978-3-642-22155-2_13
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DOI: https://doi.org/10.1007/978-3-642-22155-2_13
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