Marti G Subrahmanyam, Anurag Gupta
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.
Subrahmanyam: (212) 998-0348 msubrahma@stern.nyu.edu
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