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In-Arrears Term Structure Products: No Arbitrage Pricing Bounds And The Convexity Adjustments

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Author Info

  • AN CHEN

    ()
    (Department of Mathematics and Economics, University of Ulm, Helmholtzstrasse 20, 89069 Ulm, Germany)

  • KLAUS SANDMANN

    ()
    (Department of Economics, University of Bonn, Adenauerallee 24-42, 53113 Bonn, Germany)

Abstract

When pricing an in-arrears term structure product, the valuation usually boils down to determining the price of a vanilla product and of some additional part. To computer the price of the additional part, sometimes a specific term structure (like Gaussian or LIBOR) is assumed. Sometimes approximation methods are applied to achieve model-independent valuation formulae. In the present paper, we show that these valuation formulae (the price of vanilla products plus convexity adjustments resulting from approximation) are in effect model-independent pricing bounds in every arbitrage-free model. More specifically, they are proven to be a lower pricing bound for in-arrears payer swaps and in-arrears caps and an upper bound for in-arrears receiver swaps and in-arrears floors. To address the goodness/tightness issue of the bounds, convexity adjustments are compared with the exact pricing formulae obtained in LIBOR market model.

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Bibliographic Info

Article provided by World Scientific Publishing Co. Pte. Ltd. in its journal International Journal of Theoretical and Applied Finance.

Volume (Year): 15 (2012)
Issue (Month): 08 ()
Pages: 1250054-1-1250054-24

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Handle: RePEc:wsi:ijtafx:v:15:y:2012:i:08:p:1250054-1-1250054-24

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Related research

Keywords: In-arrears swaps; in-arrears caps and floors; convexity adjustments; pricing bounds; risk-neutral pricing; change of measure;

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