Optional: Derivation of the Approximation

with Convexity
• The second-order Taylor approximation gives
1
P( y)  P '( y)y  P ''( y)(y)2 .
2
where (y) in P(y) emphasizes the fact that P is a function of y.
• Then,
P( y) P '( y) 1 P ''( y)
 y  (y)2 .
P( y ) P( y ) 2 P( y )
• Our goal is to show
P( y) D 1
 y  C (y)2 .
P( y ) 1 y 2
 Optional: Derivation of the Approximation
with Convexity
• This means we need to show
P '( y) D P ''( y )
 ,  C.
P( y ) 1 y P( y )
• As before, for simplicity, consider a zero-coupon bond as an example.
(The face value is denoted by F.) Then, the above two equality is
straightforward since F
P( y )  ,
(1  y )
D

F D
P '( y)   D D 1
 P( y),
(1  y) 1 y
 Optional: Derivation of the Approximation
with Convexity
and
F D( D  1)
P ''( y)  D( D  1) D2
 P( y),
(1  y) (1  y) 2

where the convexity measure for this bond becomes

1 F
C D(1  D).
P( y)(1  y) (1  y)
2 D

1 D(1  D)
 P( y) D(1  D) 
P( y)(1  y) 2
(1  y)2
 Optional: Derivation of the Approximation
with Duration
• For simplicity, consider a zero-coupon bond as an example. (Recall
that duration becomes the same as maturity in this case.)
F
P .
(1  y ) D

Hence,
dP F
 D
dy (1  y) D 1
D F D
  P
1  y (1  y) D
1 y
Hence, dP D
 dy.
P 1 y