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    Topics: Convexity Immunization by Matching Convexity in Addition To Duration

    Uploaded by

    Veeken Chaglassian
    This document discusses convexity and its importance in immunization. Convexity measures how the price of a bond changes with interest rates and allows for a more accurate price approximation than duration alone, especially for large rate changes. The document provides the formulas for calculating dollar convexity and convexity. It also gives an example of determining the convexity of two bonds and shows how accounting for both duration and convexity leads to a more accurate price estimate when rates change. Finally, the document solves an example immunization problem where proportions of bonds are determined to match the duration and convexity of a perpetual liability.

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    Topics: Convexity Immunization by Matching Convexity in Addition To Duration

    Uploaded by

    Veeken Chaglassian
    35 views8 pages
    This document discusses convexity and its importance in immunization. Convexity measures how the price of a bond changes with interest rates and allows for a more accurate price approximation than duration alone, especially for large rate changes. The document provides the formulas for calculating dollar convexity and convexity. It also gives an example of determining the convexity of two bonds and shows how accounting for both duration and convexity leads to a more accurate price estimate when rates change. Finally, the document solves an example immunization problem where proportions of bonds are determined to match the duration and convexity of a perpetual liability.

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    L5-Convexity

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    This document discusses convexity and its importance in immunization. Convexity measures how the price of a bond changes with interest rates and allows for a more accurate price approximation than duration alone, especially for large rate changes. The document provides the formulas for calculating dollar convexity and convexity. It also gives an example of determining the convexity of two bonds and shows how accounting for both duration and convexity leads to a more accurate price estimate when rates change. Finally, the document solves an example immunization problem where proportions of bonds are determined to match the duration and convexity of a perpetual liability.

    Copyright:

    © All Rights Reserved
    Download as DOC, PDF, TXT or read online from Scribd
    Download as doc, pdf, or txt
    35 views8 pages

    Topics: Convexity Immunization by Matching Convexity in Addition To Duration

    Uploaded by

    Veeken Chaglassian
    This document discusses convexity and its importance in immunization. Convexity measures how the price of a bond changes with interest rates and allows for a more accurate price approximation than duration alone, especially for large rate changes. The document provides the formulas for calculating dollar convexity and convexity. It also gives an example of determining the convexity of two bonds and shows how accounting for both duration and convexity leads to a more accurate price estimate when rates change. Finally, the document solves an example immunization problem where proportions of bonds are determined to match the duration and convexity of a perpetual liability.

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    © All Rights Reserved
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    of 8

    Topics

     Convexity

     Immunization by matching convexity in addition to Duration


    Convexity:

    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.


    Time Cash Flow PV j ( j  1)C
    (1  y ) j  2
    Bond A 1 8 7.2727 12.021
    2 108 89.2562 442.593
    96.5289 454.614
    Bond B 20 100 14.864 5159.531
    $ Duration $ Convexity Convexity
    Bond A -168.899 454.614 4.71
    Bond B -270.255 5159.531 347.11

    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

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