I am looking at the valuation of an Interest Rate Swap (IRS thereafter) which is pretty much vanilla with one small tweak. Floating leg pays 3 months LIBOR in monthly intervals. To be precise: floating leg resets every month, and the 3M LIBOR prevailing at the reset date is paid out at the end of the monthly interval. Payment is of course scaled to 1 month period (multiplied by year fraction equivalent to this monthly period). I feel that I should use convexity adjustment similarly as in the case of the in arrears IRS (but the adjustment will be different this time around). Can anyone guide me to the appropriate convexity adjustment for this case?
Maturity: 5 years. Floating leg: monthly payments based on the 3M LIBOR prevailing on the reset date (reset dates occur monthly 2 business days before the start of each monthly coupon period). Fixed leg: annual fixed payments.
The closest case that I've found was in great Brigo and Mercurio book "Interest Rate Models - Theory and Practice" 13.8.5 page 566 "Forward Rates Resettung Unnaturally and Average-Rate Swap". However Brigo and Mercurio discuss contract that pays after natural payment date (and in my case it is before natural paymen date).
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