By Sanjay K. Nawalkha
This is often a fascinating examining on rate of interest threat by means of giving the fundamental perception to the true challenge, introductory.
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Additional info for Interest Rate Risk Modeling : The Fixed Income Valuation Course
For example, the convexity of a call option on a bond is generally greater than the convexity of the underlying bond since this option is a leveraged security. Similarly, the convexity of a put option on a bond is generally negative since this option represents a leveraged short position. 4 The convexity of a bond is computed identically to the duration of a bond, except that the longevity of each cash flow is replaced by the longevity squared. 2. As can be seen, convexity increases with maturity and decreases with coupon rate.
4) will depend on the confidence the hedge fund manager places in the particular types of shifts, and risk/return trade-off that she desires. For example, if she feels strongly that the slope shift will be negative, but unsure about the curvature shift, then she will take more exposure to slope shifts by increasing the D(2) of the portfolio, but have the D(3) of the portfolio close to zero. The examples above demonstrate how managers of different financial institutions with varying objectives can use various multifactor models for hedging or speculating against the risk of nonparallel yield curve shifts.
If one or more of the cash flows are negative, then duration may exceed the maturity of the underlying security, or may even be negative. Negative cash flows are introduced when computing the duration of fixed-income derivatives such as option and futures, which are priced as portfolios of long and short positions in regular bonds. 20 Total the duration of the underlying bond since this option is a leveraged security. Similarly, the duration of a put option on a bond is generally negative since this option represents a leveraged short position.
Interest Rate Risk Modeling : The Fixed Income Valuation Course by Sanjay K. Nawalkha