Suppose that you are trading a LIBOR-in-arrears swap with an unsophisticated counterparty that 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 all 12-month LIBOR forward rates 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 and no difference between the risk-free discount rate and LIBOR rates.