ENCYCLOPEDIA OF QUANTITATIVE FINANCE, R. Cont, ed., Wiley, 2009
Posted: 7 Mar 2009 Last revised: 6 May 2009
Date Written: March 6, 2009
A convexity adjustment (or convexity correction) in fixed income markets arises when one uses prices of standard (plain vanilla) products plus an adjustment to price nonstandard products. We explain the basic and appealing idea behind the use of convexity adjustments and focus on the situations of particular importance to practitioners: yield convexity adjustments, forward versus futures convexity adjustments, timing and quanto convexity adjustments. We claim that the appropriate way to look into any of these adjustments is as a side effect of a measure change, as proposed by Pelsser (2003). This approach bypasses the need for Taylor approximations or unrealistic assumptions.
Keywords: convexity adjustment, LIBOR rate, swap rates, in-arrears products, CMS, forward price, futures
JEL Classification: E43,G12
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