Convexity (finance)
In
Terminology
Strictly speaking, convexity refers to the second derivative of output price with respect to an input price. In
As the second derivative is the first non-linear term, and thus often the most significant, "convexity" is also used loosely to refer to non-linearities generally, including higher-order terms. Refining a model to account for non-linearities is referred to as a convexity correction.
Mathematics
Formally, the convexity adjustment arises from the
Geometrically, if the model price curves up on both sides of the present value (the payoff function is convex up, and is above a tangent line at that point), then if the price of the underlying changes, the price of the output is greater than is modeled using only the first derivative. Conversely, if the model price curves down (the convexity is negative, the payoff function is below the tangent line), the price of the output is lower than is modeled using only the first derivative.[clarification needed]
The precise convexity adjustment depends on the model of future price movements of the underlying (the probability distribution) and on the model of the price, though it is linear in the convexity (second derivative of the price function).
Interpretation
The convexity can be used to interpret derivative pricing: mathematically, convexity is optionality – the price of an option (the value of optionality) corresponds to the convexity of the underlying payout.
In
This value is isolated via a straddle – purchasing an at-the-money straddle (whose value increases if the price of the underlying increases or decreases) has (initially) no delta: one is simply purchasing convexity (optionality), without taking a position on the underlying asset – one benefits from the degree of movement, not the direction.
From the point of view of risk management, being long convexity (having positive Gamma and hence (ignoring interest rates and Delta) negative Theta) means that one benefits from volatility (positive Gamma), but loses money over time (negative Theta) – one net profits if prices move more than expected, and net loses if prices move less than expected.
Convexity adjustments
From a modeling perspective, convexity adjustments arise every time the underlying financial variables modeled are not a martingale under the pricing measure. Applying
- Quanto options: the underlying is denominated in a currency different from the payment currency. If the discounted underlying is martingale under its domestic risk neutral measure, it is not any more under the payment currency risk neutral measure
- Constant maturity swap (CMS) instruments (swaps, caps/floors)[2]
- mortgage-backed securities or other callable bonds
- IBOR forward rate calculation from Eurodollar futures
- IBOR forwards under LIBOR market model (LMM)
References
- Benhamou, Eric, Global derivatives: products, theory and practices, pp. 111–120, 5.4 Convexity Adjustment (esp. 5.4.1 Convexity correction) ISBN 978-981-256-689-8
- Pelsser, Antoon (April 2001). "Mathematical Foundation of Convexity Correction". )