From Harley Bassman, The Convexity Maven (accept no substitutes), February 23:
Long-time readers of these Commentaries are well aware that modesty has never been my strong suit, even when my ramblings were finely vetted by the somewhat constipated legal advisors and compliance officers employed by corporate Wall Street.
And while I am being honest, let me further reveal that my membership in the 1% is mostly owed to making every effort to be long Convexity–both personally and professionally. So, I beg you not to be fearful as we traverse the topic; I promise, if you can drive a car you already appreciate the concept, even if you cannot speak a word of Greek.
Notwithstanding that my parents believe I spent most of my career as a stockbroker, I was indeed able to explain to them the concept of Convexity.
Imagine you are placing a bet on a coin flip, and if you win you receive $3 and if you lose, you pay $2. Assuming the odds of winning or losing are the same, this would be a Positive Convexity bet because the payoff is not linear. Conversely, again assuming a fair coin flip bet of equal odds, if you could lose $5 and only win $4, that would be a Negative Convexity bet. And for completeness, a game where you would win or lose equal amounts is a zero Convexity (linear) bet.
It is for this reason Convexity is often defined as “unbalanced leverage”. It is the unbalanced prefix that is key; the return profile is not linear. The payoff function can have a bend or kink, but more often it is curved, hence its description as ‘convex’ (or sometimes ‘concave’ for negatively convex).
Clearly, if one could make positive Convexity bets for no “cost”, this would be terrific, but usually these sorts of bets, or investments for purposes of this Commentary, are not available.
While it is bad form to engage a gambling paradigm on Wall Street, it can be helpful to use a familiar pastime for illustration. When one plays Roulette at most casinos, there are 38 numbered slots on the wheel, yet a winning $1 bet only pays out $35. As such, over the course of time, one stands to win $350 versus losing $380 (or some multiple) in exchange for free drinks and a discount ticket to the floor show.
To make this a truly “fair” endeavor, the price of a $1 bet should be 94.6 cents. Thus, I have only visited Atlantic City once, when I was kidnapped for my bachelor party 33 years ago, but that’s another story.
Similarly, on Wall Street, prices of securities adjust to make investments “fair”, or at least as fair as consensus allows.
Hark back to mid-2018, when the FED (Federal Reserve Bank) had loosened its grip and bond prices were somewhat normalizing. Shown in the table below, the US Treasury seven-year note closed at par (100) to yield 3.00% while the most liquid MBS (Mortgage-backed Security) FNMA 4.0% bond traded at 101.11....
....MUCH MORE (11 page PDF)
