How to find a bond portfolio with the highest convexity in a class of fixed duration portfolios (Q1578326)

The authors consider the basic immunization problem which means the problem of finding the least expensive bond portfolio \(Z\) enable to meet the liability to pay \(C\) dollars \(K\) years from now irrespective of unknown shifts \(h_{t}\) in spot rates \(y_{t}\) to occur instantly after the acquisition of \(Z\), under the assumption that the spot rate shocks \(h_{t}\) satisfy the condition \(h_{t}/(1+y_{t})=g_{t}\cdot h_{t_1}/(1+y_{t_1})\), \(t\in T=\{t_1,t_2,\ldots,t_{n}\}\) with known coefficients \(g_{t}\). The duration \(D(Z)\) and convexity \(V(Z)\) of bond portfolio \(Z\) given respectively by the formulas \(D(Z)=\sum_{t=t_1}^{t_{n}}tg_{t} x_{t}^{Z}\), \(V(Z)={1\over 2}\sum_{t=t_1}^{t_{n}}t(t+1) g_{t}^2 x_{t}^{Z}\), where \(x_{t}^{Z}\) is the weight of all coupons generated by \(Z\) to be paid at time \(t\). Let \(Kg_{K}\) be a duration of bond whose payment occurs at time \(t=K\). The main result of the article is the following. A bond portfolio \(Z^{*}\) with the highest convexity in the class of portfolios \(Z\) satisfying \(D(Z)=Kg_{K}\) exists and appears to be a barbell strategy built up with two bonds \(B_{c}, B_{d}\).