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Valuation and Hedging of Differential Swaps

✍ Scribed by Chuang-Chang Chang; San-Lin Chung; Min-Teh Yu

Publisher
John Wiley and Sons
Year
2002
Tongue
English
Weight
158 KB
Volume
22
Category
Article
ISSN
0270-7314

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✦ Synopsis

Abstract

This paper derives a general‐form formula for pricing and hedging differential swaps with the
principal denominated either in a domestic, foreign, or third‐country currency. We first derive the
formula for differential swaps with the principal in a domestic currency and identify an error in the formula of
Wei (1994). We then show the pricing duality between differential swaps with the principal in a
domestic currency and differential swaps with the principal in a foreign currency. Finally, we complete the
pricing and hedging analysis on differential swaps by deriving a formula for differential swaps with the
principal denominated in a third‐country currency. Simulation results indicate that constant margin rates
are generally smaller than interest rate differentials and decline with the tenor of swaps. Correlation
parameters associated with the exchange rate play a more important role than correlation parameters among
interest rates in pricing differential swaps. Β© 2002 John Wiley & Sons, Inc. Jrl Fut Mark
22:73–94, 2002

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