Hedging of Interest Rate Derivatives

Abstract Interest rate derivatives are claims based on the forward rate curve, so their hedging is best understood by studying their relation to that curve. Thus, interest rate risk is tantamount to forward rate risk; we make this definition precise and display the risk of an example swap. We explain curve build methods as a choice of mapping from observable market prices to forward rates, and define their response functions , which determine the instrument hedges computed with a given curve build method. We discuss real‐world methods for approximating second‐order risks. The language of response functions can be extended to volatilities in the Heath– Jarrow– Morton (HJM) picture; using this we analyze vega‐hedging methods. Finally, we discuss the complications introduced by credit and counterparty issues.