Mathematical foundation of convexity correction
Quantitative Finance , Volume 3 - Issue 1 p. 59- 65
A broad class of exotic interest rate derivatives can be valued simply by adjusting the forward interest rate. This adjustment is known in the market as x convexity correction. Various ad hoc rules are used to calculate the convexity correction for different products, many of them mutually inconsistent. In this research paper we put convexity correction on a firm mathematical basis by showing that it can be interpreted as the side-effect of a change of probability measure. This provides us with a theoretically consistent framework to calculate convexity corrections. Using this framework we review various expressions for LIBOR in arrears and diff swaps that have been derived in the literature. Furthermore, we propose a simple method to calculate analytical approximations for general instances of convexity correction.