Calculating the Price of Bond Convexity

Abstract

The global decline in interest rates has created a significant increase in the present value of pension funds; convexity plays an important role—the convexity bias in the yield curve is well known. While the expectations hypothesis is valid for the money market sector of the yield curve, the remainder is determined by what we can call the expected volatility hypothesis, which is based on the principle of no-arbitrage between convexity and theta in the value of a bond portfolio. The results of a term structure model that constructs the yield curve using a closed-form solution are compared to actual data.

TOPICS: Pension funds, factor-based models, fixed-income portfolio management