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Bond Convexity

Convexity

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10 views2 pages

Bond Convexity

Convexity

Uploaded by

ratinderkaur855
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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BOND CONVEXITY:

The trade-off between a bond's price and its yield to maturity was not a straight line but a curved
(that is, convex) function. (See Exhibit 12.15 to review this concept.) The reason that the duration-
based prediction formula in Equation is an approximation of the actual price change that would
occur for a given yield change is that it does not take this curvature into account. That is, by only
focusing on the Mod D statistic, the formula misses the bond's convexity property. Essentially,
Equation attempts to estimate movements along a curved line with a straight (tangent) line.An
important thing to recognize in this display is that the duration-based approximation of the price-
yield relationship is always conservative in the sense that it overestimates the price decline following
a yield increase and it underestimates the price increase induced by a yield decrease. So, the
convexity property of a non-callable bond is a good thing for the investor in that it will "add back" to
the value of the instrument relative to if the duration effect alone is considered. More formally, it
also indicates that modified duration of the bond is related to the first differential of the price-yield
relationship with respect to yield:

Mod D: dP/(di/P)

Whereas convexity is related to the second derivative of this relationship:

Convexity: d^2P/(di^2P/P)

CONDITION SOLUTON:It's necessary to consider both modified duration and convexity when
estimating a bond's price volatility when the yield change is large. This is because modified duration
is only an estimate that assumes a linear relationship between price and yield, which is not accurate.

Reason:Modified duration is a metric that measures how sensitive a bond's price is to changes in
yield to maturity. However, the actual relationship between price and yield is curved, which is known
as convexity. Convexity is a measure of the curvature of the price-yield relation. The greater the
convexity, the greater the adjustment to the duration-based estimate of the change in price. When
estimating a bond's price volatility, you can use both modified duration and convexity to improve the
estimate. This allows you to estimate the price change for a wider range of changes in the yield of
the bond.

ILLUSTRATION:

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