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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.|
|Appears in Collections:||Finance Working Papers|
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