
Explanation:
An interest rate swap can be replicated using a pair of bonds:
This replication method is the easiest because:
Direct cash flow matching: The fixed payments from the swap match the coupon payments from the fixed-rate bond, while the floating payments match the floating-rate bond payments
Simplicity: Only two instruments are needed, making it straightforward to implement
Standard valuation: Bond pricing formulas are well-established and easy to apply
No complex derivatives: Unlike options or futures, bonds are simpler instruments with more transparent pricing
Option B (portfolio of interest rate options) and Option C (portfolio of interest rate futures) are more complex and require multiple positions to replicate the swap's cash flows accurately.
When pricing an interest rate swap, which of the following is the easiest to use for replicating the swap's cash flows?
A
A pair of bonds
B
A portfolio of interest rate option contracts
C
A portfolio of interest rate futures contracts
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