Duration and Convexity

Enzo Mondello
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Enzo Mondello: CfBS Center for Business Studies AG

Chapter 12 in Applied Fundamentals in Finance, 2023, pp 413-447 from Springer

Abstract: Abstract The relationship between the bond price and the expected return is negative. If the expected return increases (decreases), the price of the bond decreases (increases). The changes in the yield to maturity result from a change in the benchmark rate and the risk premium. The latter is a return compensation for credit risk of the issuer and market liquidity risk of the bond. The risk of a bond is analysed using the sensitivity measures of modified duration and modified convexity. These risk measures can be used to assess how much the bond price changes when the expected return (or the yield to maturity) moves. Duration improves with convexity in view of the fact that the relationship between price and yield to maturity of a fixed-rate bond is not linear. This chapter starts with an analysis of the risk factors relevant for bond valuation. This is followed by a presentation of the duration-convexity approach, which can be derived from the second-order Taylor series expansion. Next, Macaulay duration, modified duration, and modified convexity are described. Finally, the chapter examines applications of duration and convexity in portfolio management, which can be used for tactical asset allocation, investment strategies, such as the immunisation strategy, and for exploiting and hedging predicted interest rate and credit risk changes.

Date: 2023
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DOI: 10.1007/978-3-658-41021-6_12

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