Convexity, Risk, and Returns

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 [1978] 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