Describe the convexity of a bond. When pricing bonds under what circumstances is convexity a problem?
Describe the convexity of a bond. When pricing bonds under what circumstances is convexity a problem?
Homework Answers
Solution:
Bond price and yield are inversely related. The change in bond price can be measured by duration and convexity. Duration measures the linear relation and convexity measures the non-linear relation between bond price and yield. Convexity is basically the second derivative of the bond price with respect to the yield.
Formula for the convexity is
Limitations of convexity
- When coupon is very high then convexity will be low and it will not be very useful as change in price can be found by duration only
- For normal (straight) bonds the impact is very small as compared to bonds with special features like callable, sinking fund bonds etc.
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Describe the convexity of a bond. When pricing bonds under what
circumstances is convexity a problem?
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