Topics

 Convexity

 Immunization by matching convexity in addition to Duration

The price change of a bond for a small yield change can be written as follows using Taylor series expansion:

P 1 2P
P  x y  x y 2
y 2 y 2

When we compute the approximate price change of a bond using dollar duration, we used only the first term in this expression. This is

not sufficiently accurate for large yield changes or when very precise interest rate hedging is desired. For better immunization, use

convexity also to hedge your positions.

2P  N
j ( j  1)C N ( N  1)100 
Dollar Convexity =
y

2 =   (1  y) j2
 
(1  y ) N  2 
 j 1

and

DollarConvexity
Convexity =
P

Example: Determine the convexity of an 8% coupon bond with two years to maturity and a zero-coupon bond with 20 years to

maturity. The yield-to-maturity on these bonds is 10% p.a.

If the yield changes to 11% then the price of the bond computed using only duration is:
PB = 14.864 + $ Duration x y
= 14.864 – 270.255 x .01 = 12.161
The new price computed using both duration and convexity is:
1
PB = 14.864 + $ Duration x y + $ Convexity x (y ) 2
2
1
= 14.864 – 270.255 x .01 + x 5159.531 x .012 = 12.419
2
100
The actual price of Bond B at 11% yield is = 12.407.
(1.11) 20
Accuracy of Price Approximations based on Duration and Convexity Adjustments
Yield Today =10% $duration = -270.255 $Convexity = 5159.531
P(10%)+
yield Price of Delta y $duration* P(10%)+ Convexity Duration
20-year =y-.1 Delta y Duration Adjustment Adjustment+
 Zero Adjustment Convexity
Yield (y) Actual Adjustment
Price
100/(1+y/100)^20
(1) (2) (3) (4)= (5)=14.86+ (6)=5159*(3)^2 (7)=(5)+(6)/2
-270.255*(3) (4)
7.00 25.84 -0.030 8.11 22.97 2.32 25.29
7.50 23.54 -0.025 6.76 21.62 1.61 23.23
8.00 21.45 -0.020 5.41 20.27 1.03 21.30
8.50 19.56 -0.015 4.05 18.92 0.58 19.50
9.00 17.84 -0.010 2.70 17.57 0.26 17.82
9.50 16.28 -0.005 1.35 16.22 0.06 16.28
10.00 14.86 0.000 0.00 14.86 0.00 14.86
10.50 13.58 0.005 -1.35 13.51 0.06 13.58
11.00 12.40 0.010 -2.70 12.16 0.26 12.42
11.50 11.34 0.015 -4.05 10.81 0.58 11.39
12.00 10.37 0.020 -5.41 9.46 1.03 10.49
12.50 9.48 0.025 -6.76 8.11 1.61 9.72
13.00 8.68 0.030 -8.11 6.76 2.32 9.08
(D:\f48s00\lect5wk1)
 Price - Actual, Duration and Convexity
Adjustments
30.00

25.00

20.00
Price

15.00

10.00

5.00

0.00
7.00 7.50 8.00 8.50 9.00 9.50 Yield
10.00 10.50 11.00 11.50 12.00 12.50 13.00
Properties of Convexity

 The convexity of a zero-coupon bond is N(N+1)/(1+y)2.

 The convexity of a perpetuity is 2/y2.

 The convexity of a portfolio of bonds is the weighted average of the convexities of the underlying bonds. Specifically,

n
Cp = xC ,
i 1
i i

where n is the number of bonds in the portfolio, Ci and xi are the convexity and portfolio weight of bond i respectively.

 The dollar convexity of a portfolio of bonds is the sum of the dollar convexities of the underlying bonds. Specifically,

n
$Cp =  $C ,
i 1
i

where n is the number of bonds in the portfolio and $Ci is the dollar convexity of bond i.
Problem: XYZ has a perpetual liability of $1,000,000 per year and the current yield is 10%. In what proportions should you invest in

zero coupon bonds of 1-, 10-, and 30-year maturities so that the net worth is immunized? Match both the durations and the

convexities of the assets and liabilities.

Duration Convexity
1-year zero N 1 N(N + 1)/(1 + y)2 1.65
10-year zero N 10 N(N + 1)/(1 + y)2 90.91
30-year zero N 30 N(N + 1)/(1 + y)2 768.60
Perpetuity (1+y)/y 11 2/y2 200
Set the following conditions:

Sum of total assets equal the present value of liabilities (all dollar numbers in millions).

x1 + x10 + x30 = 10

The dollar durations of assets and liabilities should be equal.

1 1
- (x1 + 10x10 + 30x30) = x 11 x 10.
1.1 1.1

The dollar convexities of assets and liabilities should be equal.

1.65x1 + 90.91x10 + 768.60x30 = 200 x 10.

The solution to the above set of equations is: x1 = 3.48; x10 = 4.45; and x30 = 2.07.
 Matching assets and liabilities on convexity, in addition to durations, allow for a closer match of assets and liabilities for larger

changes in interest rates

 When both convexities and durations are matched less frequent rebalancing will be necessary compared with matching only on

durations