Interest rate convexity and the volatility smile

Wolfram Boenkost and Wolfgang M. Schmidt

No 4, CPQF Working Paper Series from Frankfurt School of Finance and Management, Centre for Practical Quantitative Finance (CPQF)

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 replication (search for similar items in EconPapers)
JEL-codes: G13 (search for similar items in EconPapers)
Date: 2006
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (7)

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Persistent link: https://EconPapers.repec.org/RePEc:zbw:cpqfwp:4

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