CONVEXITY AND IMMUNIZATION

BY MATCHING CONVEXITY IN
ADDITION TO DURATION

By NUSRAT KHAN
 Convexity
2

 Measures how much a bond’s price-yield curve deviates from a

straight line
 Second derivative of price with respect to yield divided by bond price

 2P 1 N
 CFt 
2 y (1  y)2 
  t
(t 2
 t) 
t 1 (1
 y) 
1 2 P
Convexity 
P 2 y

 Allows us to improve the duration approximation for bond price

changes
 Convexity
16-3

 The relationship between bond prices and yields

is not linear.

 Duration rule is a good approximation for only

small changes in bond yields.

 Bonds with greater convexity have more

curvature in the price-yield relationship.
 Bond Price Convexity: 30-Year Maturity, 8%
Coupon; Initial YTM = 8%
16-4
 Convexity
16-5

1 n
 CFt 
Convexity 
P  (1  y ) 2   (1  y ) t (t  t )
t 1 
2

Correction for Convexity:

P 1
  D  y  [Convexity  (y ) ]
2

P 2
 Convexity of Two Bonds
16-6
 Why do Investors Like Convexity?
16-7

 Bonds with greater curvature gain more in

price when yields fall than they lose when
yields rise.
 The more volatile interest rates, the more

attractive this asymmetry.

 Bonds with greater convexity tend to have

higher prices and/or lower yields, all else

equal.
 Predicted percentage price change
8

 Recall approximation using only duration:

P
 100  Dm*  y  100
P

 The predicted percentage price change accounting

for convexity is:

P 1
 100   Dm  y  100  
*
 Convexity  (y)2  100
P 2 
Bond
Coupon Rate 10%
Par Value 100
Years Mat 2
YTM 15%

Macaulay
PV of Duration
Time (1) Cash Flow (2) Cash (4) =
Flows (1)x(3)/Pric Convexity
e
1Coupon 10 8.69565 0.094650 13.150
Bond A Coupon +
2 Principal 110 83.17580 1.810700 377.357
91.87146 1.905350 390.507
Bond B 20Principal 100 6.11003 20 1940.425

Modified Dollar Change in Bond Price Change in Bond Price

Macaulay Δp = Δy x (4) Dollar
Convexity Δp = Δy x (4) + 0.5*(6)*Δy
2
Duration Duration
Bond (1) Duration Covexity
(3) = (4) = - Δy = .005 Δy = .01 (7)
(2) (6) Δy = .005 Δy = .01
(2)/(1+y) P*(3)
A 1.9053 1.6568 -152.2150 -0.7611 -1.5222 390.507 4.2506 -0.7562 -1.5026
B 20.0000 17.3913 -106.2614 -0.5313 -1.0626 1940.424 317.5803 -0.5071 -0.9656
Convexity: Properties
 The convexity of a zero-coupon bond is N(N+1)/(1+y) 2.
 The convexity of perpetuity is 2/y 2.
 The convexity of a portfolio of bonds is the weighted
average of the convexities of the underlying bonds.
Specifically,

When n is the number of bonds in the portfolio, Ci and xi

are the convexity and portfolio weight of bond i
respectively.
Convexity: Properties
 The dollar convexity of a portfolio of bonds is the
sum of the dollar convexities of the underlying
bonds. Specifically,

When n is the number of bonds in the portfolio,

and $Ci is the dollar convexity of bond i
respectively.
Brainstorming !!!!
 AON has a perpetual liability of $1m per year
and the current yield is 10%. In what
proportions should the firm invest in zero
coupon bonds of 1, 15, and 25 year maturities
so that the net worth is immunized? Match
both the durations and the convexities of the
assets and liabilities.
 Duration Convexity
1 yr zero N 1 N(N+1)/(1+y)2 1.65
15 yr zero N 15 N(N+1)/(1+y)2 198.35
25 yr zero N 25 N(N+1)/(1+y)2 537.19
Perpetuity (1+y)/y 11 2/y2 200

Sum of total assets equal the present value of liabilities

x1 + x15 + x25 = 10
The $Durations of assets and liabilities should be equal
-1/1.1(x1 + 15x15 + 25x25 ) =( -1/1.1)*11*10
The $Convexities of assets and liabilities should be equal
1.65 x1 + 198.35x15 + 537.19x25 = 200*10
Find x1 , x15 , x25 = ????
Immunization by Matching Duration and
Convexity

 The strategy of immunizing by matching duration

and convexities of assets and liabilities attempts to
match the present values of assets and liabilities at
all levels of interest rates. This will ensure that the
assets will always be sufficient to meet liabilities
regardless of changes in interest rate.
 To implement this, match present values of assets
and liabilities and also match their dollar durations
and also match convexities.
Immunization by Matching Duration and
Convexity

 The cash flow matching approach matches each

individual cash flow of the liability with equal cash
flows from assets. The duration matching approach to
immunization matches the present values of cash
flows from assets and liabilities.
 Under the duration matching approach, the cash flows
from the asset portfolio need not exactly match the
cash flows to meet liability stream. But the idea is that
if the cash flows are not exactly matched some of the
assets can be sold to raise cash and meet liabilities.
 You have a perpetual liability of $1m. The yield curve is
flat at 10%. You plan to immunize your net worth using
two zero coupon securities with maturities of 5 years and
10 years.
a) How much will you invest in each of these
securities?
b) Will you be immunized with the position identified
in “part a” if the yield changes to 10.5%? Why or why
not?
c) Will you be immunized with the position identified
in “part a” if the yield remains at10%? Why or why not?
We can start with three alternative investments to verify the asset liability conditions.
1. X5 = 10m, X20 = 0m
2. X5 = 0m, X20 = 10m
3. X5 = 7.5m, X20 = 2.5m

x5 Investment in 5-year Zero

x10 Investment in 10-year Zero
Price of $100 face value 5-yr Zero at y=10% 62.09
Price of $100 face value 10-yr Zero at y=10% 38.55
Yield Present Value
of Liability Portfolio

(y) =$1m/(1+y) x5=10,x10=0 x5=0,x10=10 x5=75%,x20=25%

9.5 10.53 10.23 10.47 10.29
10 10.00 10.00 10.00 10.00
10.5 9.52 9.78 9.56 9.72
 Macaulay’s Duration Dollar Duration
Y= .1 Y=.11 Y= .1 Y= .1 Y=.11 Y= .1
1 yr later 1 yr later
Perpetuity 11 10.09 11 -100 -82.63 -100
5-yr Zero 5 5 4 -4.54X5 -4.50X5 -3.64X4
10-yr zero 10 10 9 -9.09X10 -9.00X10 -8.18X9

1. Set value of assets to equal value of liability

X5 + X10 = 10
2. Set $Duration of assets and Liability equal
-4.54X5 – 9.09X10 = -100
3. Repeat the steps for y = 11%
4. Repeat the steps for y = 10% for 1 year later.
CF Matching Vs. Duration
Matching
The cash flow matching strategy has the following
advantages:
 The liabilities will always be met with the cash

flows from the assets regardless of any future

change in interest rates.
 This strategy will enable immunization at the

lowest cost.
 Once the assets and liabilities are matched on cash

flows no portfolio revision is necessary.

CF Matching Vs. Duration
Matching
However,
 Cash flow matching strategy can not be applied if the

future cash flows are not known with certainty.

 In such situations match present values of future cash

flows from assets to present values of the liability

stream- Match dollar durations.
 A position that is immunized by duration matching at

one point in time need not stay immunized with

changes in interest rates or with the passage of time.