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How can I exploit an arbitrage by violating the following no-arbitrage condition (taken from the paper "Arbitrage-Free Construction of the Swaption Cube" by Simon Johnson and Bereshad Nonas):

Swptn(K,T1,T2)+Swptn(K,T2,T3) >= Swptn(K,T1,T3) with Swptn(A,B,C) being the price of a swaption of strike A, time to option maturity B, time to underlying swap maturity C.

Thanks for any hints. L.

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Exploiting an arbitrage is straightforward. Constructing and noticing one is the hard part. In your case if you know that Swptn(K,T1,T2)+Swptn(K,T2,T3) >= Swptn(K,T1,T3),

Simply sell Swptn(K,T1,T2)+Swptn(K,T2,T3) and buy Swptn(K,T1,T3). Sell the most expensive and buy the cheapest.

L.

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  • $\begingroup$ Dear L.,thank you very much for your complete answer. Now I can truly become rich with your smart strategy! $\endgroup$
    – user20100
    Commented Apr 11, 2016 at 8:50

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