Duration, Convexity and Multiple-Factor Models
Jan 1, 1988
A substantial proportion of pension portfolios worldwide are invested in bonds. This large allocation clearly indicates that sponsors should carefully scrutinize the risk and monitor the returns of their bond positions. Unfortunately, bond portfolios are not as simple to analyze as they once were. Investment in more complex instruments has caused considerable problems for both sponsors and money managers. One reason for this is that the traditional tool for analyzing bond portfolios, duration, is less effective in volatile environments and when bonds have embedded options. A more direct approach -- the use of a multiple-factor model – is described here in the context of an immunization strategy. The multiple-factor model is shown to directly solve many of the shortcomings of the traditional approaches.