Valuation and hedging of differential swaps in a general form

Abstract

This paper develops a pricing and hedging model for differential swaps in a general form . In summary, the contributions of this paper are threefold . Firstly, we find out one error in the pricing formula developed by Wei ( 1994) and derive the correct one. Secondly, we propse a proposition which reveals the dual pricing relationship between a differential swap with domestic currency denominated principal and a differential swap with foreign currency denominated principal . Thirdly, we derive a pricing and hedging model for differential swaps with third country currency denominated principal . Hence this paper provides complete solutions for pricing and hedging differential swaps. Department of Finance, National Central University, Chung- Li 320, Taiwan. Tel : 886-3-4227424, Fax: 886-3-4252961, e-mail: ccchang@cc.ncu.edu.tw. The earlier version of this paper was presented in the 1997 annual meeting of Chinese Finance Association, the fifth annual conference of the Multinational Finance Society, and the 1998 meeting of Financial Management Association. We are especially grateful to Andrew Chen, Son-Nan Chen, Alberto Moel for helpful comments and discussions. Corresponding author: Chang.