Debt Instruments and Markets Professor Carpenter

Convexity 1
!"#$%&'()
!"#+%,(- .#/ 01223"4/-
Dollai Convexiiy
Convexiiy
Cuivaiuie
Tayloi seiies
Baibell, Bullei
5%./'#6-
Veionesi, Clapiei (
Tuclman, Clapieis and 6
Debt Instruments and Markets Professor Carpenter
Convexity 2
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Convexiiy is a measuie of ile cuivaiuie of ile value of
a secuiiiy oi poiifolio as a funciion of inieiesi iaies.
Duiaiion is ielaied io ile slope, i.e., ile fisi deiivaiive.
Convexiiy is ielaied io ile cuivaiuie, i.e. ile second
deiivaiive of ile piice funciion.
Using convexiiy iogeilei wiil duiaiion gives a beiiei
appioximaiion of ile clange in value given a clange in
inieiesi iaies ilan using duiaiion alone.
P
i
i
c
e

Inieiesi Raie (in decimal)
Example: Secuiiiy wiil Posiiive Convexiiy
74'+%85.(% 91#+:"#
Lineai
appioximaiion of
piice funciion
Approximation
error
Debt Instruments and Markets Professor Carpenter
Convexity 3
!"44%+:#6 (;% <14.:"# =44"4
Tle piice-iaie funciion is nonlineai.
Duiaiion and dollai duiaiion use a lineai
appioximaiion io ile piice iaie funciion io measuie
ile clange in piice given a clange in iaies.
Tle eiioi in ile appioximaiion can be subsianiially
ieduced by maling a convexiiy coiieciion.
>.)?"4 @%4'%-
Tle Tayloi Tleoiem fiom calculus says ilai ile value
of a funciion can be appioximaied neai a given poini
using iis "Tayloi seiies" aiound ilai poini.
Using only ile fisi iwo deiivaiives, ile Tayloi seiies
appioximaiion is:
!
f (x) " f (x
0
) + f ' (x
0
) #(x $ x
0
) +
1
2
f ' ' (x
0
) #(x $ x
0
)
2
Or, f (x) $ f (x
0
) " f ' (x
0
) #(x $ x
0
) +
1
2
f ' ' (x
0
) #(x $ x
0
)
2
Debt Instruments and Markets Professor Carpenter
Convexity 4
<"??.4 !"#$%&'()
Tlinl of bond piices, oi bond poiifolio values, as
funciions of inieiesi iaies.
Tle Tayloi Tleoiem says ilai if we lnow ile fisi and
second deiivaiives of ile piice funciion (ai cuiieni iaies),
ilen we can appioximaie ile piice impaci of a given
clange in iaies.
! Tle fisi deiivaiive is minus dollai duiaiion.
! Call ile second deiivaiive Jollor convexity.
Tlen clange in piice = -sduiaiion x clange in iaies
+ o. x sconvexiiy x clange in iaies squaied

!
f (x) " f (x
0
) # f ' (x
0
) $(x " x
0
) + 0.5 $ f ' ' (x
0
) $(x " x
0
)
2
<"??.4 !"#$%&'() "A . 7"4B"?'"
If we assume all iaies clange by ile same amouni, ilen
tbe Jollor convexity of o portfolio is tbe sum of tbe Jollor
convexities of its securities.
Sleicl of pioof:
I.e., ! portfolio value " - (sum of dollai duiaiions) x !r
+ 0.5 x (sum of dollar convexities) x (!rates)
2
! Poiifolio dollai duiaiion = sum of dollai duiaiions
! Poiifolio dollai convexiiy = sum of dollai convexiiies

!
f
i
(x) " f
i
(x
0
)
#
$ f
i
' (x
0
)
# ( )
%(x " x
0
) + 0.5 % f
i
' ' (x
0
)
# ( )
%(x " x
0
)
2
Debt Instruments and Markets Professor Carpenter
Convexity 5
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}usi as dollai duiaiion desciibes dollai piice sensiiiviiy,
dollai convexiiy desciibes cuivaiuie in dollai peifoimance.
To gei a scale-fiee cuivaiuie measuie, i.e., cuivaiuie pei
dollai invesied, we defne
! Tbe convexity of o portfolio is tbe overoqe convexity of its
securities, weiqbteJ by present volue.
}usi lile dollai duiaiion and duiaiion, dollai convexiiies
add, convexiiies aveiage.
!
convexity =
dollar convexity
price
!
convexity =
price
i
"
# convexity
i
price
i
"
= pv wtd average convexity
<"??.4 9"4C1?.- A"4 DE 7.4 "A . F%4"
Foi si pai of a t-yeai zeio-coupon bond
!
price = d
t
(r
t
) =
1
(1+ r
t
/2)
2t
dollar duration = - d
t
' (r
t
) =
t
(1+ r
t
/2)
2t +1
dollar convexity = d
t
' ' (r
t
) =
t
2
+ t /2
(1+ r
t
/2)
2t +2
Foi sN pai, ilese would be muliiplied by N.
Debt Instruments and Markets Professor Carpenter
Convexity 6
7%4+%#( 9"4C1?.- A"4 G#) GC"1#( "A . F%4"
!
duration =
dollar duration
price
=
N " t /(1+ r
t
/2)
2t +1
N "1/(1+ r
t
/2)
2t
=
t
1+ r
t
/2
convexity =
dollar convexity
price
=
N "(t
2
+ t /2) /(1+ r
t
/2)
2t +2
N "1/(1+ r
t
/2)
2t
=
t
2
+ t /2
(1+ r
t
/2)
2
Tlese foimulas lold foi any pai amouni of ile zeio - iley aie
scale-fiee.
Tle duiaiion of ile t-yeai zeio is appioximaiely t.
Tle convexiiy of ile t-yeai zeio is appioximaiely t
:
.
(If we defned piice as J
t
= e
-rt
, and dieieniiaied w.i.i. ilis r,
ilen ile duiaiion of ile t-yeai zeio would be exacily t and ile
convexiiy of ile t-yeai zeio would be exacily t
:
.)

!?.-- 74"H?%C-
Calculaie ile piice, dollai duiaiion, and dollai
convexiiy of si pai of ile :o-yeai zeio if r
:o
= 6.o%.
Debt Instruments and Markets Professor Carpenter
Convexity 7
!?.-- 74"H?%C-
Suppose r
:o
iises io y.o%.
i) Appioximaie ile piice clange of si,ooo,ooo pai using
only dollai duiaiion.
:) Appioximaie ile piice clange of si,ooo,ooo using
boil dollai duiaiion and dollai convexiiy.
) Wlai is ile exaci piice clange?
!?.-- 74"H?%C-
Suppose r
:o
falls io .o%.
i) Appioximaie ile piice clange of si,ooo,ooo pai using
only dollai duiaiion.
:) Appioximaie ile piice clange of si,ooo,ooo using
boil dollai duiaiion and dollai convexiiy.
) Wlai is ile exaci piice clange?
Debt Instruments and Markets Professor Carpenter
Convexity 8
@.C,?% 5'-I J%.-14%-
!"#$%&#' )"#* +%&,* -.$%"/01 .$%"/01 -2013*4&#' 2013*4&#'
56 78669 68::;7<7 :8;<:=>; >8<6?<= :=8<>?< >?8><@7
@6 78:69 68@<?@@7 :8;?>;7= 5>8;<6=7 56<866=; ;?=8:>:5
;6 78=69 685:56?= =8;>5><= @>867><< 5@>8?65: ?:>85;:7
Duiaiion and convexiiy foi si pai of a
io-yeai, :o-yeai, and o-yeai zeio.
Foi zeioes,
duiaiion is iouglly equal io maiuiiiy,
convexiiy is iouglly equal io maiuiiiy squaied.
<"??.4 !"#$%&'() "A . 7"4B"?'" "A F%4"%-
Considei a poiifolio wiil fxed casl ows ai dieieni
poinis in iime (K
i
, K
:
, . , K
n
ai iimes t
i
, t
:
, ., t
n
).
}usi as wiil dollai duiaiion, ile dollai convexiiy of ile
poiifolio is ile sum of ile dollai convexiiies of ile
componeni zeioes.
Tle dollai convexiiy of ile poiifolio gives ile coiieciion
io male io ile duiaiion appioximaiion of ile clange in
poiifolio value given a clange in zeio iaies, assuming all
zeio iaies clange by ile same amouni.
!
portfolio dollar convexity = K
j
j=1
n
"
#
t
j
2
+ t
j
/2
(1+ r
t
j
/2)
2t
j
+2
Debt Instruments and Markets Professor Carpenter
Convexity 9
!?.-- 74"H?%CK
<"??.4 !"#$%&'() "A . 7"4B"?'" "A F%4"%-
Considei a poiifolio consisiing of
s:,iy( pai value of ile io-yeai zeio,
sqi,SqS pai value of ile o-yeai zeio.
Wlai is ile dollai convexiiy of ile poiifolio?
!"#$%&#' )"#* +%&,* -.$%"/01 .$%"/01 -2013*4&#' 2013*4&#'
56 78669 68::;7<7 :8;<:=>; >8<6?<= :=8<>?< >?8><@7
@6 78:69 68@<?@@7 :8;?>;7= 5>8;<6=7 56<866=; ;?=8:>:5
;6 78=69 685:56?= =8;>5><= @>867><< 5@>8?65: ?:>85;:7
!"#$%&'() "A . 7"4B"?'" "A F%4"%-
!
convexity =
$convexity
present value
=
K
j
j=1
n
"
#
t
j
2
+ t
j
/2
(1+ r
t
j
/2)
2t
j
+2
K
j
(1+ r
t
j
/2)
2t
j
j=1
n
"
=
K
j
(1+ r
t
j
/2)
2t
j
#
t
j
2
+ t
j
/2
(1+ r
t
j
/2)
2
j=1
n
"
K
j
(1+ r
t
j
/2)
2t
j
j=1
n
"
= average convexity weighted by present value
$ average maturity
2
weighted by present value
Debt Instruments and Markets Professor Carpenter
Convexity 10
!?.-- 74"H?%C
Considei ile poiifolio of io- and o-yeai zeioes.
Tle io-yeai zeioes lave mailei value
s:,iy( x o.6y6 = si,qS.
Tle o-yeai zeioes lave mailei value
sqi,SqS x o.iioS( = si,SS(.
Tle mailei value of ile poiifolio is s:y,S::.
Wlai is ile convexiiy of ile poiifolio?
!"#$%&#' )"#* +%&,* -.$%"/01 .$%"/01 -2013*4&#' 2013*4&#'
56 78669 68::;7<7 :8;<:=>; >8<6?<= :=8<>?< >?8><@7
@6 78:69 68@<?@@7 :8;?>;7= 5>8;<6=7 56<866=; ;?=8:>:5
;6 78=69 685:56?= =8;>5><= @>867><< 5@>8?65: ?:>85;:7
0.4H%??- .#/ 01??%(-
Considei iwo poiifolios wiil ile same duiaiion:
A borbell consisiing of a long-ieim zeio and a
sloii-ieim zeio
A bullet consisiing of an inieimediaie-ieim zeio
Tle baibell will lave moie convexiiy.
Debt Instruments and Markets Professor Carpenter
Convexity 11
Bullei poiifolio: sioo,ooo pai of :o-yeai zeioes
mailei value = sioo,ooo x o.:yS:: = :y,S::
duiaiion = iq.y
Baibell poiifolio: fiom pievious example
s:,iy( pai value of ile io-yeai zeio
sqi,SqS pai value of ile o-yeai zeio.
mailei value = :y,S::
Tle convexiiy of ile bullei is S.
Tle convexiiy of ile baibell is (yS.
!
duration =
(13,938 "9.70874) + (13,884 "29.06977)
13,938 +13,884
=19.37
=&.C,?%
In ile pievious example,
ile duiaiion of ile bullei is aboui :o and
ile convexiiy of ile bullei is aboui :o
:
=(oo.
Tle duiaiion of ile baibell is aboui
o. x io + o. x o = :o
bui ile convexiiy is aboui
o. x io
:
+ o. x o
:
= oo > (oo = (o. x io + o. x o)
:
I.e., ile aveiage squaied maiuiiiy is gieaiei ilan ile aveiage
maiuiiiy squaied.
Indeed, iecall Vai(X) = E(X
2
)-(E(X))
2

Tlinl of casl ow maiuiiiy t as ile vaiiable and pv weiglis as
piobabiliiies. Duiaiion is lile E(t) and convexiiy is lile E(t
2
).
So convexiiy = duiaiion
:
+ dispeision (vaiiance) of maiuiiiy.
@%+14':%- 3'(; 9'&%/ !.-; 9?"3-K
J"4% /'-,%4-% +.-; L"3-M C"4% +"#$%&'()
Debt Instruments and Markets Professor Carpenter
Convexity 12
N.?1% "A 0.4H%?? .#/ 01??%(
!
Barbell : V
2
(s) =
25,174
(1+ (0.06 + "r) /2)
20
+
91,898
(1+ (0.064 + "r) /2)
60

Bullet : V
1
(s) =
100,000
(1+ (0.065 + "r) /2)
40
Ai cuiieni iaies,
iley lave ile same value
and ile same slope (duiaiion).
Bui ile baibell las moie cuivaiuie (convexiiy).
!!
<"%- (;% 0.4H%?? G?3.)- O1(,%4A"4C (;%
01??%(P
If ileie is an immediaie paiallel slifi in inieiesi iaies,
eiilei up oi down, ilen ile baibell will ouipeifoim ile
bullei.
If ile slifi is noi paiallel, anyiling could lappen.
If ile iaies on ile bonds siay exacily ile same, ilen as
iime passes ile bullei will aciually ouipeifoim ile
baibell:
ile bullei will ieiuin 6.%
ile baibell will ieiuin aboui 6.:%, ile mailei value-
weiglied aveiage of ile 6% and 6.(% on ile io- and
o-yeai zeioes.
Debt Instruments and Markets Professor Carpenter
Convexity 13
N.?1% "A 0.4H%?? .#/ 01??%(K
O#% Q%.4 R.(%4
If ile iaies don'i
clange, ile bullei will
be woiil moie.
If ileie is a laige enougl
paiallel yield cuive slifi,
Tle baibell will be woiil
moie.
!"#$%&'() .#/ (;% @;.,% "A (;% Q'%?/ !14$%P
If ile yield cuive weie ai and made paiallel slifis, moie convex
poiifolios would always ouipeifoim less convex poiifolios, and
ileie would be aibiiiage.
So io ile exieni ilai mailei movemeni is desciibed by paiallel
slifis, bulleis musi lave liglei yield io siaii wiil, io
compensaie foi lowei convexiiy.
Tlis would explain wly ile ieim siiuciuie is ofien lump-
slaped, dipping down ai veiy long maiuiiiies wleie convexiiy is
gieaiesi ielaiive io duiaiioninvesiois may give yield io buy
convexiiy.
Some evidence suggesis ilai ile yield cuive is moie cuived
wlen volaiiliiy is liglei and convexiiy is woiil moie.