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Answer: DV01, because the effective duration calculated for this position may not be meaningful in these circumstances
## Explanation **B is correct** because DV01 is the most appropriate risk measure for interest rate swaps when the contract value is near zero. ### Key Reasons: - **Effective duration** expresses interest rate sensitivity as a percentage change in value, which becomes problematic when the initial value is close to zero. A percentage change from near-zero can be mathematically undefined or misleading. - **DV01** (Dollar Value of 01 basis point) measures the absolute dollar change in value for a 1 basis point change in interest rates, making it meaningful regardless of the initial position value. ### Why other options are incorrect: - **A is incorrect**: Effective duration actually expresses sensitivity as a percentage change, not a currency amount. - **C is incorrect**: DV01 can be calculated for derivative contracts including interest rate swaps. - **D is incorrect**: DV01 is specifically designed for small changes (1 basis point) and becomes less accurate for larger rate changes, not more accurate. ### Learning Objective: This question addresses the comparison between DV01 and effective duration as measures of price sensitivity, particularly in the context of derivative instruments with near-zero initial values.
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A derivatives trader at an investment bank has initiated an interest rate swap contract today with an institutional client. The current value of the trader's position in the contract is near zero. The trader considers using either DV01 or effective duration to measure the interest rate sensitivity of the position and assess by how much its value could decline if the term structure of spot rates moves unfavorably. What would be the most appropriate measure for the analyst to use to quantify the interest rate risk of the contract, and why?
A
DV01, because effective duration expresses interest-rate sensitivity as a currency amount rather than as a percentage
B
DV01, because the effective duration calculated for this position may not be meaningful in these circumstances
C
Effective duration, because DV01 cannot be calculated for a position in a derivative contract
D
Effective duration, because DV01 is only accurate when estimating the effect of a large change in interest rates