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http://hdl.handle.net/2451/27059
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| Title: | An Empirical Examination of the Convexity Bias in the Pricing of
Interest Rate Swaps |
| Authors: | Subrahmanyam, Marti G.
Gupta, Anurag |
| Issue Date: | Apr-1998 |
| Series/Report no.: | FIN-98-068 |
| Abstract: | This paper examines the convexity bias introduced by pricing interest
rate swaps off the Eurocurrency futures curve and the incorporation of
this bias in prices over time. The convexity bias arises because of the
difference between a futures versus 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 swaps markets - $, ',', and DM
- and implied rates cannot be explained by default risk differences,
term structure effects, liquidity differences or information asymmetries
between the swaps and the futures markets. Using a calibrated term
structure model, the theoretical value of the convexity bias is found to
be comparable to the empirically observed spread. This is evidence of
mispricing of swap rates during the earlier years of the study, with a
gradual elimination of that mispricing by incorporation of a convexity
adjustment in swap pricing over time. |
| URI: | http://hdl.handle.net/2451/27059 |
| Appears in Collections: | Finance Working Papers
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