Let's say we have a situation where all 12-month LIBOR forward rates at 8% per annum with annual compounding. All cap volatilities are 16%. Estimates 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 5 years and 10 years. Also, assume a notional principal of $1 million and no difference between the risk-free discount rate and LIBOR rates

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    $\begingroup$ You would probably get better or quicker help if you could also describe how you have tried solving this problem and exactly where you have failed. $\endgroup$
    – Alper
    Nov 24 at 20:14
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    $\begingroup$ Hmm, "unsophisiticated" means ignoring convexity adjustment? $\endgroup$ Nov 24 at 20:59
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    $\begingroup$ I think @DimitriVulis got the point. The unsophisticated would simply use forward rates. The sophisticated one would subtract the convexity adjustment. The longer is the swap’s tenor, the bigger is the difference in swap’s NPV. Remind me Hull’s textbook questions :) $\endgroup$ yesterday

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