An Empirical Examination of the Convexity Bias in the Pricing of Interest Rate Swaps

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.