Is convexity efficiently priced? Evidence from international swap markets

Abstract

While it is widely claimed in the literature that convexity is correctly priced, we find evidence in four major swap markets that this is the case only on average and that extended periods occur when convexity-based trading strategies offer economically very significant exceptional returns. These abnormal returns can be reaped with fully no-peek-ahead strategies and after accounting for transaction costs. We find a strong link between the periods of highest profitability and conditions of reduced market liquidity. This suggests that, as observed in recent liquidity studies on US Treasuries, temporary deviations from market efficiency at the long end of the swap curve occur when pseudo-arbitrageurs do not have sufficient capital to correct the mispricings. • Convexity is not always correctly priced in the four most important swap markets. • Two strategies that exploit these inefficiencies are economically very significant. • Both strategies are most effective in conditions of poor market liquidity. • We explain the source of the economic differences between the two strategies.