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Convexity Bias in the Pricing of Eurodollar Swaps

Author

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  • V. Pozdnyakov

    (University of Connecticut)

  • J.M. Steele

    (University of Pennsylvania, Steinberg Hall-Dietrich Hall 3000, University of Pennsylvania)

Abstract

The traditional use of LIBOR futures prices to obtain surrogates for the Eurodollar forward rates is proved to yield a systematic bias in the pricing of Eurodollar swaps when one assumes that the yield curve is well described by the Heath-Jarrow-Morton model. The resulting theoretical inequality is consistent with the empirical observations of Burghardt and Hoskins (1995), and it provide a theoretical basis for price anomalies that are suggested by more recent empirical data.

Suggested Citation

  • V. Pozdnyakov & J.M. Steele, 2002. "Convexity Bias in the Pricing of Eurodollar Swaps," Methodology and Computing in Applied Probability, Springer, vol. 4(2), pages 181-193, June.
    • Handle: RePEc:spr:metcap:v:4:y:2002:i:2:d:10.1023_a:1020693608365
    DOI: 10.1023/A:1020693608365
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    References listed on IDEAS

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    1. Grinblatt, Mark & Jegadeesh, Narasimhan, 1996. "Relative Pricing of Eurodollar Features and Forward Contracts," Journal of Finance, American Finance Association, vol. 51(4), pages 1499-1522, September.
    2. Harrison, J. Michael & Pliska, Stanley R., 1981. "Martingales and stochastic integrals in the theory of continuous trading," Stochastic Processes and their Applications, Elsevier, vol. 11(3), pages 215-260, August.
    3. David Heath & Robert Jarrow & Andrew Morton, 2008. "Bond Pricing And The Term Structure Of Interest Rates: A New Methodology For Contingent Claims Valuation," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 13, pages 277-305, World Scientific Publishing Co. Pte. Ltd..
    4. Amin, Kaushik I. & Morton, Andrew J., 1994. "Implied volatility functions in arbitrage-free term structure models," Journal of Financial Economics, Elsevier, vol. 35(2), pages 141-180, April.
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    Cited by:

    1. Vladimir Pozdnyakov & J. Michael Steele, 2009. "Convexity Bias in Eurodollar Futures Prices: A Dimension-Free HJM Criterion," Methodology and Computing in Applied Probability, Springer, vol. 11(4), pages 551-560, December.

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