LIBOR-IN-ARREARS SWAPS.

LIBOR-in-arrears swaps differ from regular swaps in that each payment is based on the LABOR at the end of the payment period. For a regular swap it is the beginning-of- period LABOR that is paid at the end of the payment period. This mismatch in cash flow timing makes the present value of a floating payment in a LABOR-in-arrears swap not equal to the present value of the forward rate for that date. This difference, known as the convexity adjustment, depends on the volatilities of interest rates. We derive exact and approximate solutions for the convexity adjustment that use only the LIBOR yield and volatility curves, both of which are readily observable in the interest rate swap and cap markets. Numerical examples show that for reasonable parameter values the adjustment for pricing in arrears can be 2 to 3 basis points on the ten-year swap rate. [ABSTRACT FROM AUTHOR]