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Pat
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Posts: 28
Joined: September 30th, 2001, 2:08 am

Convexity corrections ...

March 19th, 2019, 3:02 pm

Replication is used for many convexity corrections (for CMS caps, floors, and swaps; for Libor set in arrears and other mismatched simple rates; for IRR settled swaps and swaptions). It's a major pain in the ... neck, because it can introduce risks to high strike options. Often strikes high enough that "market price" is a polite fiction. Recently we've received many new requests for our original paper on using convexity corrections via replication ("Convexity conundrums: Pricing CMS swaps, caps, and floors" in Wilmott, 2003). However, since that paper was published, we've derived explicit expressions for valuing quadratic swaps, caps, and floors under the SABR model, and used this to analyze convexity corrections. We believe this provides a better approach than replication does: It's easier to program and sounder operationally as it doesn't re-cast the risks into high strike options. We hope to make this public domain very shortly, a few weeks. If you're planning to implement convexity corrections via replication, you may want to hold off a bit.