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I recently heard that for a forward swap rate (for example, the fixed rate of a swap that will start in one year and end in five years), I need to do a convexity adjustment in order to get the right number. Is it true, and if so why?

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The question in this form is incomplete. The swap rate alone does not need any convexity adjustment. You have to specify how this rate is paid. –  Christian Fries Apr 26 '13 at 18:16
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5 Answers

Yes, an adjustment has to be made and the reason is that a forward curve now will evolve and not be the same as the future spot curve. For example, a one year forward today is not equal to your spot rate a year hence. So spot curve discount factors have to be adjusted or directly replaced through the forward DFs.

Convexity adjustments are already supposed to be made during the forward libor curve construction.

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A forward starting swap needs adjustment, yes, but in discounting terms rather than convexity. IRSs are linear AFAIK; if expected Libors rose 1bp, that would raise the par fixed rate 1bp. I'm assuming no optionality in the swap. –  Phil H Apr 26 '13 at 9:02
    
Sorry, I was very vague and it was probably misleading. Convexity adjustments still have to be made but its more during the libor forward curve built-out (off the euro$ futures). Thanks for pointing that out. Will edit my answer. –  Matt Wolf Apr 26 '13 at 10:22
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First of all it is not clear what exactly you mean by right number, you definitely do not adjust forward swap rate.

You probably mean adjusting euro dollar futures contract rates so that you can later use these values to fit the swap/forward libor curve.

Reason for adjustment is simple. If you are short ED futures and rates go higher futures price drops and you make money. Clearing house of exchange reimburses you excess margin and you can reinvest them at higher rate. If rates go lower you have to put extra cash into your margin account, you can borrow this money at lower rate.

Assuming some distribution and forward rate model(and here things vary from simple vasicek model to extremely complicated example Peterbarg) one can compute how much this advantage is in dollars and convert it to basis points.

Pure intuition tells that longer is the expiry higher is the adjustment also higher is the vol higher is the adjustment.

So the end result is that being short gives you advantage and market participants are aware of it and penalize short side by that amount.

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The convexity adjustment needed for futures comes from the margining applied to the (undiscounted) future price. In contrast, swaps are collateralized by discounted value, such that a future-like convexity adjustment does not apply. However, if a forward swap rate is paid in an unnatural way (like in a CMS), a convexity adjustment applies. –  Christian Fries Apr 26 '13 at 18:45
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For a vanilla forward-start swap, I would agree with imachabeli; convexity is an adjustment for the non-linearity of the quoted fixed rate dependence on the floating note. If expected Libors rise 1bp, the fixed leg can be increased 1bp to compensate.

Convexity adjustments are made as standard to interest rate futures (i.e. 3m); with the next futures date (Jun13) 2 months away, the front contract convexity adjustment is less than .1bp, so it makes no real difference. By contrast at 5y (Jun18), the 21st contract convexity is around 15bp.

It is possible the question is about swap futures, which deal over the futures dates, and which are therefore forward starting. As these are also futures, and deliver margin payments, there is a convexity adjustment to be made as per 3m futures.

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good point made at the end, indeed the question may actually be about swap futures. –  Matt Wolf Apr 26 '13 at 10:31
    
OK. If this is about swap futures, then he should be more precise... –  Christian Fries Apr 26 '13 at 18:46
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Given an index $t \mapsto S(t)$ (this may be a forward swap rate) and some value process $t \mapsto A(t)$ (this may be a swap annuity) we assume that $S/A$ is a traded product (which is true if $S$ is the forward swap rate and A is the corresponding (!) swap annuity. Then the future payoff $S(T) \cdot A(T)$ can be values as $S(t) \cdot A(t)$ (since $S$ is a martingale under the measure $Q^A$).

Now, if we consider the payoff $S(T) \cdot P(T)$ (say for example if $P$ is the zero coupon bond with maturity $T$) then the value can be expressed as $S'(t) \cdot P(t)$ where $S'(t)$ is the so called convexity adjusted rate, that is $S'(t) = E(S(T) \cdot \frac{P(T)/P(t)}{A(T)/A(t)})$ (with expectation under $Q^A$). The convexity adjustment is a correlation term coming from the correlation of the index to the change of the payment.

That said: If you need a convexity adjustment depends on how the index is paid.

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Most likely the question is about CMS rate convexity adjustment. i.e. today value of a swap rate that fixes at some future time T.

Mathematically, the adjustment arises from different measures (annuity versus forward measure).

This is a good reference http://www.math.nyu.edu/~alberts/spring07/Lecture4.pdf

As a rule of thumb, the size of the adjustment depends on

  1. CMS maturity
  2. Level of vol
  3. skew

For the latter the classical reference is http://www.gorillasci.com/documents/convexity.pdf

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