Interest Rate Convexity and the Volatility Smile

28 Pages Posted: 10 Apr 2009

See all articles by Wolfram Boenkost

Wolfram Boenkost

Lucht Probst Associates GmbH

Wolfgang M. Schmidt

Frankfurt School of Finance & Management

Date Written: April 9, 2009

Abstract

When pricing the convexity effect in irregular interest rate derivatives such as, e.g., Libor-in-arrears or CMS, one often ignores the volatility smile, which is quite pronounced in the interest rate options market. This note solves the problem of convexity by replicating the irregular interest flow or option with liquidly traded options with different strikes thereby taking into account the volatility smile. This idea is known among practitioners for pricing CMS caps. We approach the problem on a more general scale and apply the result to various examples.

Keywords: interest rate options, volatility smile, convexity, option

JEL Classification: G13

Suggested Citation

Boenkost, Wolfram and Schmidt, Wolfgang M., Interest Rate Convexity and the Volatility Smile (April 9, 2009). Available at SSRN: https://ssrn.com/abstract=1375581 or http://dx.doi.org/10.2139/ssrn.1375581

Wolfram Boenkost

Lucht Probst Associates GmbH ( email )

Grosse Gallusstr. 9
Frankfurt, 60311
Germany

HOME PAGE: http://www.l-p-a.com

Wolfgang M. Schmidt (Contact Author)

Frankfurt School of Finance & Management ( email )

Adickesallee 32-34
Frankfurt am Main, 60322
Germany

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
453
Abstract Views
2,145
rank
68,399
PlumX Metrics