In-Arrears Term Structure Products: No Arbitrage Pricing Bounds And The Convexity Adjustments
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.
Volume (Year): 15 (2012)
Issue (Month): 08 ()
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- A. Pelsser, 2003. "Mathematical foundation of convexity correction," Quantitative Finance, Taylor & Francis Journals, vol. 3(1), pages 59-65.
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