The Equilibrium Models of Bond Pricing and Duration Measures: A New Perspective
22 Pages Posted: 12 May 2011
Date Written: May 1, 2011
A new approach to the conditions that a duration measure must satisfy to represent the interest rate risk adequately is proposed in this paper. These conditions are derived from an intertemporal model of utility maximization. In addition, this approach is used to provide a new perspective on the arbitrage opportunities arising from the convexity effect on hedged bond portfolios. For several decades this has been considered in the literature as the main cause of the incompatibility between the traditional duration measures of Macaulay (1938), Fisher and Weil (1971), and other “immunizing” duration measures and the equilibrium models of bond pricing. Using empirical data, this paper shows that convexity effect on the rates of return on bonds is not completely eliminated, when the duration measures derived from equilibrium models of Vasicek (1977) and of Cox, Ingersoll and Ross (1985) are used in hedging strategies. The empirical analysis also shows that the influence of convexity on bond returns depends on the magnitude of interest rate changes.
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