Stochastic durations, the convexity effect, and the impact of interest rate changes

José Soares da Fonseca

The European Journal of Finance, 2014, vol. 20, issue 11, 994-1007

Abstract: This article shows that the equilibrium models of bond pricing do not preclude arbitrage opportunities caused by convexity. Consequently, stochastic durations derived from these models are limited in their ability to act as interest rate risk measures. The research of the present article makes use of an intertemporal utility maximization framework to determine the conditions under which duration is an adequate interest rate risk measure. Additionally, we show that zero coupon bonds satisfy those equilibrium conditions, whereas coupon bonds or bond portfolios do not as a result of the convexity effect. The results are supported by empirical evidence, which confirms the influence of convexity on the deviation of coupon bond returns from equilibrium.

Date: 2014
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Persistent link: https://EconPapers.repec.org/RePEc:taf:eurjfi:v:20:y:2014:i:11:p:994-1007

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DOI: 10.1080/1351847X.2013.791631

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