Contents
1 Introduction
2
1.1 Basic Concepts: CMT and CMS rates. . . . . . . . . . . . . . . . .
2
1.2 Description of the Constant Maturity Swap. . . . . . . . . . . . . .
2
1.3 Pricing of Constant Maturity Swaps. . . . . . . . . . . . . . . . . .
4
1.3.1 Convexity Adjustment to the Forward Swap Rates. . . . . .
4
1.3.2 Interest Rate Models. . . . . . . . . . . . . . . . . . . . . . .
5
1.4 Assumptions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5
2 The Pricing Framework
6
2.1 No-ArbitragePricing. . . . . . . . . . . . . . . . . . . . . . . . . . .
6
2.2 Change of Num\u00b4eraire. . . . . . . . . . . . . . . . . . . . . . . . . . .
7
2.2.1 TheRadon-Nikod\u00b4
ym Theorem. . . . . . . . . . . . . . . . .
7
2.2.2 Alternative Probability Measures. . . . . . . . . . . . . . . .
8
2.2.3 The T-Forward Measure. . . . . . . . . . . . . . . . . . . . .
8
2.2.4 The Swap Measure. . . . . . . . . . . . . . . . . . . . . . . .
9
3 Pricing of More Complex Swaps
12
3.1 The Forward Swap Rates. . . . . . . . . . . . . . . . . . . . . . . . 12
3.2 LIBOR-in-ArrearsSwap. . . . . . . . . . . . . . . . . . . . . . . . . 13
3.3 Constant Maturity Swap. . . . . . . . . . . . . . . . . . . . . . . . . 14
4 Convexity Adjustments
16
4.1 The Yield Convexity Adjustment. . . . . . . . . . . . . . . . . . . . 16
4.1.1 Derivation of the Adjustment. . . . . . . . . . . . . . . . . . 16
4.1.2 Extension of the Yield Convexity Adjustment. . . . . . . . . 18
4.2 The Standard Convexity Adjustment Model. . . . . . . . . . . . . . 21
4.3 Forward CMS Rates. . . . . . . . . . . . . . . . . . . . . . . . . . . 24
4.4 The Linear Swap-Rate Model. . . . . . . . . . . . . . . . . . . . . . 27
5 Numerical Comparisons
29
A Useful Calculations
33
B Derivation of the Standard Convexity Adjustment Model
34
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