Hull book - convexity adjustment

sigmaPi · August 19th, 2008, 7:47 am

Fifth International edition; page 536 (appendix 22A) - shows the derivation of the Convexity adjustment formula.There Hull states that Et[(Yt-Y0)^2] is approximately Sy^2*Y0^2*t.Yt ... bond yield at time tY0 ... forward bond yield observed today for a contract with maturity tSy ...Vol of forward bond yieldI can't see how. Any help appreciated!Sig.

sigmaPi · August 20th, 2008, 7:07 am

Ping!Please, pretty please!

sportbilly · August 20th, 2008, 8:26 pm

Hull is basically saying that the bond yield is log-normal under the world that is risk-neutral with respect to the price at t of the $1 zero-coupon bond maturing on T).Then y(T)-y(0) is essentially a (scaled) sum of Wiener increments. Each infinitesimal increment has variance =dy(t)=ydt+SydW(t)E(dy(t)^2)=Sy^2y^2

sigmaPi · August 21st, 2008, 4:08 am

Thanks very much!Helped a lot!Regards,Sig