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Convexity gains from a long volatility position

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Question: You are given a 30-year bond with yield y. The yield curve is flat and will have only parallel shifts. You have a liquid 3-month Eurodollar contract at your disposition. You can also borrow and lend at a rate of 5% initially.

a. Using the long bond and the Eurodollar contract, construct a delta-hedged portfolio that is immune to interest rate changes.

b. Now suppose you observe the following interest rate movements over a period of 1 year:

{0.06, 0.04, 0.06, 0.04, 0.06, 0.04}

These observations are each 2 months apart. What are your convexity gains from a long volatility position?

Reference no: EM131697034

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