Publication detail

Valuation of Convexity Related Derivatives

Author(s): RNDr. Jiří Witzany Ph.D.,
Type: IES Working Papers
Year: 2008
Number: 4
ISSN / ISBN:
Published in: IES Working Papers 4/2008
Publishing place: Prague
Keywords: interest rate derivatives, Libor in arrears, constant maturity swap, valuation models, convexity adjustment
JEL codes: C13, E43, E47, G13
Suggested Citation: Witzany, J. (2008). “ Valuation of Convexity Related Derivatives ” IES Working Paper 4/2008. IES FSV. Charles University.
Abstract: We will investigate valuation of derivatives with payoff defined as a nonlinear though close to linear function of tradable underlying assets. Derivatives involving Libor or swap rates in arrears, i.e. rates paid in a wrong time, are a typical example. It is generally tempting to replace the future unknown interest rates with the forward rates. We will show rigorously that indeed this is not possible in the case of Libor or swap rates in arrears. We will introduce formally the notion of plain vanilla derivatives as those that can be replicated by a finite set of elementary operations and show that derivatives involving the rates in arrears are not plain vanilla. We will also study the issue of valuation of such derivatives. Beside the popular convexity adjustment formula, we will develop an improved two or more variable adjustment formula applicable in particular on swap rates in arrears. Finally, we will 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 will illustrate the techniques and different results on a case study of a real life controversial exotic swap.
Downloadable: WP 2008_04_Witzany

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