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I have a problem with the underlying assumption in the future/forward convexity adjustment. If I understand correctly, the assumption is, if I am long ED, I earn money when rates go down and invest the money in a lower rate and vice versa. What I don't agree with is that the correlation between the spot rate and for example EDU5 is very far from 1, sometimes it is even negative (especially in a crisis). So I may earn money on long EDU5 and invest the earnings in a higher rate, as the spot rate is going high as well.

  1. Do most models assume 1 correlation between the spot rate and the forward rate?
  2. Any models thay take the correlation under consideration?
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    $\begingroup$ My thoughts are that I am missing a concrete question. $\endgroup$
    – vonjd
    Jul 16, 2013 at 13:07
  • $\begingroup$ I guess the question is "why is the standard convexity adjustment wrong according to current market rates?" $\endgroup$
    – Phil H
    Jul 16, 2013 at 13:14
  • $\begingroup$ I'am afraid that all the models for convexity adjustements I have seen state these values are correlated. This is a common case where models differ from market datas. $\endgroup$ Jul 16, 2013 at 13:19
  • $\begingroup$ I think it is not the aim of this community to "guess questions" ...voting to close. $\endgroup$
    – vonjd
    Jul 16, 2013 at 13:26
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    $\begingroup$ @user5726: edit your question instead of posting comments. $\endgroup$ Jul 17, 2013 at 20:39

1 Answer 1

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I have traded those convexity adjustments for many years. Any decent model of these adjustments allows the user to vary the correlation as they please, rather than assuming something. If it is of interest, the implied correlations usually trade significantly under 1, especially in periods when the curve is volatile. ie when forward rates might be going in different direction to the short end.

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