Convexity Bias in Eurodollar Futures Prices: A Dimension-Free HJM Criterion

Vladimir Pozdnyakov () and J. Michael Steele ()
Additional contact information
Vladimir Pozdnyakov: University of Connecticut
J. Michael Steele: Wharton School, Huntsman Hall 447, University of Pennsylvania

Methodology and Computing in Applied Probability, 2009, vol. 11, issue 4, 551-560

Abstract: Abstract In the theory of interest rate futures, the difference between the futures rate and forward rate is called the “convexity bias,” and there are several widely offered reasons why the convexity bias should be positive. Nevertheless, it is not infrequent that the empirical the bias is observed to be negative. Moreover, in its most general form, the benchmark Heath–Jarrow–Morton (HJM) term structure model is agnostic on the question of the sign of the bias; it allows for models where the convexity bias can be positive or negative. In partial support of the practitioner’s arguments, we develop a simple scalar condition within the HJM framework that suffices to guarantee that the convexity bias is positive. Moreover, when we check this condition on the LIBOR futures data, we find strong empirical support for the new condition. The empirical validity of the sufficient condition and the periodic observation of negative bias, therefore leads one to a paradoxical situation where either (1) there are arbitrage possibilities or (2) a large subclass of HJM models provide interest rate dynamics that fail to capture a fundamental feature of LIBOR futures.

Keywords: Heath–Jarrow–Morton model; Eurodollar futures; Convexity bias; Futures rate; Forward rate; Primary 91B28; Secondary 60H05, 60G44 (search for similar items in EconPapers)
Date: 2009
References: View references in EconPapers View complete reference list from CitEc
Citations:

Downloads: (external link)
http://link.springer.com/10.1007/s11009-008-9082-6 Abstract (text/html)
Access to the full text of the articles in this series is restricted.

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:spr:metcap:v:11:y:2009:i:4:d:10.1007_s11009-008-9082-6

Ordering information: This journal article can be ordered from
https://www.springer.com/journal/11009

DOI: 10.1007/s11009-008-9082-6

Access Statistics for this article

Methodology and Computing in Applied Probability is currently edited by Joseph Glaz

More articles in Methodology and Computing in Applied Probability from Springer
Bibliographic data for series maintained by Sonal Shukla () and Springer Nature Abstracting and Indexing ().