An empirical examination of the convexity bias in the pricing of interest rate swaps

This paper examines the convexity bias, caused by the non-linearity of payo ffs, in the pricing of interest rate swaps off the Eurocurrency futures cur ve. The evidence from four major currencies - $, pound, DM and Yen - during 1987-1996 suggests that swaps were initially being priced off the futures curve (ignoring the convexity adjustment); subsequently, the market swap ra tes drifted below the rates implied by futures prices. After rejecting alte rnative explanations, we use alternative term structure models to show that the convexity bias is related to the empirically observed swap-futures dif ferential. We interpret these results as evidence of mispricing of swap con tracts during the early years, which was eliminated over time. (C) 2000 Els evier Science S.A. All rights reserved. JEL classification: G13; G14.