Valuation of volatility sensitive interest rate derivatives in an emerging market

We investigate valuation of volatility sensitive interest rate derivatives like the derivatives involving LIBOR or swap rates in arrears. The paper studies several alternatives of the standard convexity adjustment formula, in particular, a precise analytical formula based on an assumption of log-normality of the underlying assets applicable to a wide class of derivatives. The second problem is estimation of interest rate volatilities and correlations that are used by the formulas. We analyse possible estimation methods including an application of the HJM, LIBOR market model and the swap market model. We argue that the latter is the best in a market where swap quotes are the primary source of market information on the term structure of interest rates dynamics. We illustrate the techniques and different results on a case study of a real life controversial exotic swap.