Prague Economic Papers 2009, 18(4):309-326 | DOI: 10.18267/j.pep.356

Valuation of Convexity Related Interest Rate Derivatives

Jiří Witzany

University of Economics, Prague.

We investigate valuation of derivatives with payoff deined as a nonlinear though close to linear function of tradable underlying assets. Interest rate derivatives involving Libor or swap rates in arrears, i.e. rates paid at wrong time, are a typical example. It is generally tempting to replace the future unknown interest rates with the forward rates. We show rigorously that indeed this is not possible in the case of Libor or swap rates in arrears. We introduce formally the notion of linear plain vanilla derivatives as those that can be replicated by a inite set of elementary operations and show that derivatives involving the rates in arrears are not (linear) plain vanilla. We also study the issue of valuation of such derivatives. Beside the popular convexity adjustment formula, we develop an improved two or more variable adjustment formula applicable in particular on swap rates in arrears. Finally, we get a precise fully analytical formula based on the usual assumption of log-normality of the relevant tradable underlying assets applicable to a wide class of convexity related derivatives. We illustrate the techniques and different results on a case study of a real life controversial exotic swap.

Keywords: interest rate derivatives, Libor in arrears, constant maturity swap, valuation models, convexity adjustment

JEL classification: C13, E43, E47, G13

Published: January 1, 2009  Show citation