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http://hdl.handle.net/2451/26711
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| Title: | An Empirical Examination of the Convexity Bias in the Pricing of
Interest Rate Swaps |
| Authors: | Gupta, Anurag
Subrahmanyam, Marti G. |
| Issue Date: | Feb-1999 |
| Series/Report no.: | FIN-99-001 |
| Abstract: | This paper examines the convexity bias introduced by pricing interest
rate swaps off the Eurocurrency futures curve and the market's
adjustment of this bias in prices over time. The convexity bias arises
because of the difference between a futures contract and a forward
contract on interest rates, since the payoff to the latter is non-linear
in interest rates. Using daily data from 1987-1996, the differences
between market swap rates and the swap rates implied from Eurocurrency
futures prices are studied for the four major interest rate swap markets
- $, £, DM and ¥. The evidence suggests that swaps were being
priced off the futures curve (i.e. by ignoring the convexity adjustment)
during the earlier years of the study, after which the market swap rates
drifted below the rates implied by futures prices. The empirical
analysis shows that this spread between the market and futures-implied
swap rates cannot be explained by default risk differences, liquidity
differences or information asymmetries between the swap and the futures
markets. Using alternative term structure models (one-factor Vasicek,
Cox-Ingersoll and Ross, Hull and White, Black and Karasinski, and the
two factor Heath, Jarrow and Morton), the theoretical value of the
convexity bias is found to be related to the empirically observed
swap-futures differential. We interpret these results as evidence of
mispricing of swap contracts during the earlier years of the study, with
a gradual elimination of that mis pricing by incorporation of a
convexity adjustment in swap pricing over time. |
| URI: | http://hdl.handle.net/2451/26711 |
| Appears in Collections: | Finance Working Papers
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