31. August 2006

Interest Rate Convexity and the Volatility Smile

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…

Key words: interest rate options, volatility smile, convexity, option replication

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