An Empirical Examination of the Convexity Bias in the Pricing of Interest Rate Swaps

This paper examines the convexity bias introduced by pricing interest rate swaps off the Eurocurrency futures curve and the market's adjustment of this bias in prices over time. Theconvexity bias arises because of the difference between a futures versus a forward contract on interest rates, since the payoff to the latter is non-linear in interest rates. Using daily data from 1987-1996, the differences between market swap rates and the swap rates implied from Eurocurrency futures prices are studied for the four major interest rate swap markets - $, u, DM and ?. The evidence suggests that swaps were being priced off the futures curve (i.e. by ignoring the convexity adjustment) during the earlier years of the study, after which the market swap rates drifted below the rates implied by futures prices. The empirical analysis shows that this spread between the market and futures-implied swap rates cannot be explained by default risk differences, term structure effects, liquidity differences or information asymmetries between the swap and the futures markets. Using alternative term structure models (Vasicek, Cox-Ingersoll and Ross, Hull and White, and Black and Karasinski), the theoretical value of the convexity bias is found to be related to the empirically observed swap-futures differential. This is evidence of mispricing of swap rates during the earlier years of the study, with a gradual elimination of that mispricing by incorporation of a convexity adjustment in swap pricing over time