Convexity Adjustments
Correct linear forward intuition when payoff and discounting are nonlinear.
Name the object before manipulating it.
Correct linear forward intuition when payoff and discounting are nonlinear. Fix the information set, units and market convention before using the relationship in pricing or risk.
Correct linear forward intuition when payoff and discounting are nonlinear.
State the governing relationship.
Notation and units
Decimal rates and volatilities, year-fraction time and continuous compounding unless stated otherwise.
Draw the boundary of the claim.
Definitions, units and information sets are fixed before the mathematical relationship is applied.
Rates and volatilities use decimal units and time uses year fractions unless stated otherwise.
The relationship is local to its stated assumptions and should not be extrapolated mechanically.
“An unstated convention is a future reconciliation break.”— THEQUANTBATEMAN
Connect the definition to an observable.
Convexity Adjustments connects an observable IR quantity to valuation, scenario analysis or hedge interpretation. The desk view depends on units, timestamp and quotation convention.
Translate the concept into a risk question.
State the convention, identify the observable and ask which IR risk remains after the proposed hedge.
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