I’m facing some problems trying to comprehend what is being discussed under one of the Professor’s notes ( Page 121 of fixed income AR#56- Fundamentals of Credit Analysis)
_ Make sure the value of convexity is scaled correctly.For option-free bonds, convexity should be on the same order of magnitude as modified duration squared. For example, if… duration is 6.0 and convexity is 0.562,… the correctly scaled convexity is 56.2. _
Question 1: What does this mean by “order of magnitude” and “modified duration squared”?
Question 2: Can someone provide me with a simple hypothetical example?
For your kind consideration, thank you
My understanding of this concept is the scale of convexity needs to be in line w/ duration squared. In this case duration squared = 36, so a convexity of 56.2 is the correct scale/context, not .562).
Thanks, I have difficulties understanding it.
Why is the convexity 56.2 not 0.562^2 since duration has been squared?
They’re just saying that convexity needs to be in XX.X format, that’s all.
Don’t overthink it!
Its merely a decimal alignment / scaling with squared MD i.e. 36.00 align the convexity in the same order (two decimal shifting to right) i.e. 56.2
0.562 would have been correct if the squared MD was computed as 0.360…
Correct me if I’m wrong
Convexities are often divided by 100. There’s no rational reason for doing so, of which I’m aware.
Another stupid thing that finance types do.