Convexity, Risk, and Returns
16 Pages Posted: 30 Apr 2007
Date Written: March 1993
This paper tests empirically whether convexity is return enhancing (the traditional view based upon parallel term structure shifts), or return diminishing (the equilibrium view suggesting convexity is priced). Results of empirical tests over different time periods show bond convexity to be either insignificantly or negatively related to ex-ante bond returns. These results are consistent with the critique of the traditional duration model by Ingersoll, Skelton, and Weil  and suggest that bond convexity may be priced. Further, the magnitude of bond convexity is shown to be related directly to the immunization risk inherent in a bond portfolio, consistent with the implications of Fong and Vasicek's [1983, 1984] M-Square model.
Keywords: Convexity, risk, immunization, bonds, M-Square, hedging
JEL Classification: G11, G12, G13, G21, G22, G32
Suggested Citation: Suggested Citation