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sol2
Topic Author
Posts: 4
Joined: November 4th, 2018, 8:41 pm

Value of irregular floating coupon

November 6th, 2018, 2:51 pm

I don’t know theoretically accurate solution to the following problem that I frequently face valuing irregular floating rate notes. Can somebody help me out?

Problem
Let’s assume that there is a market of zero-coupon risk-free bonds.
Price of a bond at time t with maturity at T and face=1 is P(t,T).
Bond’s interest rate is R(t,T) = (1/P(t,T)-1)/(T-t).
Forward interest rate from T_1 to T_2 at t is F(t,T_1,T_2) = (P(t,T_1)/P(t,T_2) – 1)/(T_2 – T_1).
There is a tradable derivative “f” that pays R(T_1, T_2) (interest rate R fixed at T_1) at T_3>T_2.

Question
What is value of “f” at t=0?

The question is trivial for the case T_3=T_2: f(0) = P(0,T_2)*F(0,T_1,T_2) – “discounted forward rate”. Is it possible to find f(0) for T_3>T_2?
 
sol2
Topic Author
Posts: 4
Joined: November 4th, 2018, 8:41 pm

Re: Value of irregular floating coupon

November 9th, 2018, 7:17 am

Come on! It should be a simple question for those who know theory... :-( Anyone?
 
User avatar
bearish
Posts: 3772
Joined: February 3rd, 2011, 2:19 pm

Re: Value of irregular floating coupon

November 9th, 2018, 3:36 pm

As long as T_3 is different from T_2 you need a model to calculate what is usually (if somewhat sloppily) referred to as the convexity adjustment. This adjustment would be applied to the zero volatility value of P(0,T_3)*F(0,T_1,T_2).

You might have received a quicker response if posting in the Student forum.
 
sol2
Topic Author
Posts: 4
Joined: November 4th, 2018, 8:41 pm

Re: Value of irregular floating coupon

Yesterday, 2:19 pm

Thank you, bearish!
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