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A Martingale Result for Convexity Adjustment in the Black Pricing Model

Author

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  • Eric Benhamou

    (Goldman Sachs International)

Abstract

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.

Suggested Citation

  • Eric Benhamou, 2002. "A Martingale Result for Convexity Adjustment in the Black Pricing Model," Finance 0212005, University Library of Munich, Germany.
    • Handle: RePEc:wpa:wuwpfi:0212005
    Note: Type of Document - PDF; prepared on windows; pages: 118
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    File URL: https://econwpa.ub.uni-muenchen.de/econ-wp/fin/papers/0212/0212005.pdf
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    References listed on IDEAS

    as
    1. Eric Benhamou, 2000. "Pricing Convexity Adjustment with Wiener Chaos," FMG Discussion Papers dp351, Financial Markets Group.
    2. Harrison, J. Michael & Kreps, David M., 1979. "Martingales and arbitrage in multiperiod securities markets," Journal of Economic Theory, Elsevier, vol. 20(3), pages 381-408, June.
    3. 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.
    4. French, Kenneth R., 1983. "A comparison of futures and forward prices," Journal of Financial Economics, Elsevier, vol. 12(3), pages 311-342, November.
    5. Benhamou, Eric, 2000. "Pricing convexity adjustment with Wiener chaos," LSE Research Online Documents on Economics 119104, London School of Economics and Political Science, LSE Library.
    6. Black, Fischer, 1976. "The pricing of commodity contracts," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 167-179.
    Full references (including those not matched with items on IDEAS)

    Citations

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    Cited by:

    1. Didier Kouokap Youmbi, 2012. "Yield to maturity modelling and a Monte Carlo Technique for pricing Derivatives on Constant Maturity Treasury (CMT) and Derivatives on forward Bonds," Papers 1204.4631, arXiv.org.
    2. Jiří Witzany, 2009. "Valuation of Convexity Related Interest Rate Derivatives," Prague Economic Papers, Prague University of Economics and Business, vol. 2009(4), pages 309-326.
    3. A. Pelsser, 2003. "Mathematical foundation of convexity correction," Quantitative Finance, Taylor & Francis Journals, vol. 3(1), pages 59-65.
    4. Eric Benhamou, 2000. "Pricing Convexity Adjustment with Wiener Chaos," FMG Discussion Papers dp351, Financial Markets Group.
    5. Leccadito, Arturo & Tunaru, Radu S. & Urga, Giovanni, 2015. "Trading strategies with implied forward credit default swap spreads," Journal of Banking & Finance, Elsevier, vol. 58(C), pages 361-375.

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    More about this item

    Keywords

    Martingale; Convexity Adjustment; Black and Black Scholes volatility; CMS rates.;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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