This paper explains how to calculate convexity adjustment for interest rates derivatives when assuming a deterministic time dependent volatility, using martingale theory. The motivation of this paper lies in two directions. First, we set up a proper no-arbitrage framework illustrated by a relationship between yield rate drift and bond price. Second, making ap-proximation, we come to a closed formula with speci…cation of the error term. Earlier works (Brotherton et al. (1993) and Hull (1997)) assumed constant volatility and could not specify the approximation error. As an application, we examine the convexity bias between CMS and forward swap rates.
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Paper provided by EconWPA in its series Finance with number
0212005.
Find related papers by JEL classification: G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
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