Return Impact vs Price Impact

CFA Level I Fixed Income
#1

Hi everyone,

in Reading 57 (Fund of Credit Analysis) the concept of ’ Price Impact’ is introduced (which is called ’ Return Impact’ in Schweser notes, although I do not see why, because we are computing the effect on the price. In fact in Reading 56 they even have a blue box where the concept is applied and called ’ price effect of spread changes’, but I am digressing). I have two questions:

  1. Isn’t this the exact same thing as what we learned in Reading 56, where we computed the percentage change in price of a bond in response to change in YTM, while taking mod. duration and convexity into account?

  2. Unlike Reading 56, this time the curriculum and Schweser Notes point out the importance of remembering to scale the convexity correctly but neither of them provide any further explanation or exercises. This is all that is provided:

"In this case, one must be careful to ensure that convexity (denoted by Cvx) is appropriately scaled to be consistent with the way the spread change is expressed. In general, for bonds without embedded options, one can scale convexity so that it has the same order of magnitude as the duration squared and then express the spread change as a decimal. For example, for a bond with duration of 5.0 and reported convexity of 0.235, one would re-scale convexity to 23.5 before applying the formula. For a 1 percent (i.e., 100 bps) increase in spread, the result would be

Price impact = (–5.0 × 0.01) + ½ × 23.5 × (0.01)2 = –0.048825 or –4.8825 percent"

I don’t quite understand how I am supposed to scale it correctly? Should I just multiply any convexity that is smaller than 1 by 100 in case the duration is also larger than 1? What is the duration is larger than 10 or smaller than 1?

#2

In case someone else is having difficulties with 2) as well. I think (or guess) that the authors of the curriculum and the Schweser notes are refererring to the fact that a convexity smaller than 1, might be an indication that the number has not been converted to percentages yet, and therefory needs to be multiplied by 100.

However, there are numerous examples in Schweser and the curriculum where the convexity expressed in percent is still smaller than 1, so I am still not sure about this one.