Suppose that you are trading a LIBOR-in-arrears swap with an unsophisticated counter- party who does not make
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Suppose that you are trading a LIBOR-in-arrears swap with an unsophisticated counter- party who does not make convexity adjustments. To take advantage of the situation, should you be paying fixed or receiving fixed? How should you try to structure the swap as far as its life and payment frequencies? Consider the situation where the yield curve is flat at 10% per annum with annual compounding. All cap volatilities are 18%. Estimate the difference between the way a sophisticated trader and an unsophisticated trader would value a LIBOR-in-arrears swap where payments are made annually and the life of the swap is
(a) 5 years,
(b) 10 years, and
(c) 20 years. Assume a notional principal of $1 million.
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