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Title:Interest rate convexity and the volatility smile PDF Logo
Authors:Boenkost, Wolfram
Schmidt, Wolfgang M.
Issue Date:2006
Series/Report no.:CPQF Working Paper Series 4
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.
Subjects:interest rate options
volatility smile
convexity,
option replication
JEL:G13
Document Type:Working Paper
Appears in Collections:CPQF Working Paper Series, Frankfurt School of Finance and Management

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