First Duration, Then Convexity, Then What? Tilt?

Abstract

Standard treatments of the impact of interest rate changes on bond prices include duration and convexity. These concepts derive from the first and second derivatives of a Taylor series expansion of an option-free bond price as a function of interest rates. Does the third derivative matter? This paper derives the formula for the third derivative- based term, which we call tilt, and explores its properties. Tilt tells how quickly the convexity changes. Similar to the properties of duration, a higher yield reduces tilt, a longer maturity increases tilt, and a higher coupon reduces tilt, ceteris paribus. Tilt adds little to the accuracy of the impact of small interest rate changes for default-free option-free bonds. Tilt becomes interesting for bonds with embedded options such as callable bonds and mortgage-backed securities. Such bonds can experience rapidly changing convexity and price under certain interest rate regimes.

Keywords: Duration, Convexity, Tilt, Bond Prices, Embedded Options, Mortgage-Backed Securities

JEL Classification: G10