Explanation:
B is correct. DV01 is likely to be the most appropriate risk measure for interest rate swaps. Effective duration is not a meaningful measure in this situation because the value of the contract is close to zero. Effective duration expresses sensitivity as a percentage change in value divided by a change in yield; when the value of the position is near zero, this percentage becomes extremely large or unstable and therefore not meaningful.
A is incorrect. Effective duration expresses the impact of rate changes on the position's value as a percentage, not a currency amount. DV01 expresses the impact as a currency amount.
C is incorrect. DV01 can be calculated for any position whose value depends on interest rates, including interest rate derivatives such as swaps.
D is incorrect. DV01 describes the impact of a 1-bp change in interest rates, for which it is most accurate. It becomes less accurate as it is applied to larger interest rate changes.
Learning Objective: Compare and contrast DV01 and effective duration as measures of price sensitivity.
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Q-15. 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