ABSTRACT
In this chapter we consider the effect of changes in the interest rate on a set of assets which come due at various times in the future (a portfolio). The chapter begins with the concepts of duration (relative rate of change of price with respect to the interest rate) and convexity (which depends on the second derivative of the price with respect to the interest rate). These are used to estimate the new price given a small change in interest rates. The first and second degree Taylor Polynomials are used to make this estimate as well as a slightly more accurate measure which depends only on the convexity. Finally a more sophisticated strategy for asset matching making use of duration and convexity is discussed.
