Valuation and hedging of differential swaps

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. © 2002 John Wiley & Sons, Inc.