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Convexity and Duration: Shows How Much A Bond's Price Changes in Response To A Change in Yield

- A bond's price-yield relationship is convex, forming a curved graph rather than a straight line. The degree of curvature indicates how much a bond's price changes with yield. - The linear tangent drawn at a point on the curved price-yield curve represents the bond's duration. The point where the tangent touches is called Macaulay duration. - Convexity accounts for inaccuracies that can occur when using duration to estimate price changes from large yield variations, as duration only approximates the linear relationship. Bonds with higher convexity experience smaller price changes with interest rate movements.

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47 views3 pages

Convexity and Duration: Shows How Much A Bond's Price Changes in Response To A Change in Yield

- A bond's price-yield relationship is convex, forming a curved graph rather than a straight line. The degree of curvature indicates how much a bond's price changes with yield. - The linear tangent drawn at a point on the curved price-yield curve represents the bond's duration. The point where the tangent touches is called Macaulay duration. - Convexity accounts for inaccuracies that can occur when using duration to estimate price changes from large yield variations, as duration only approximates the linear relationship. Bonds with higher convexity experience smaller price changes with interest rate movements.

Uploaded by

Rabeya Aktar
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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For any given bond, a graph of the relationship between price and yield (price-yield curve) is

convex. This means that the graph forms a curve rather than a straight-line (linear). The
degree to which the graph is curved shows how much a bond's price changes in response to
a change in yield.

Convexity and Duration

If a tangent is drawn at a particular price of bond (touching a point on the curved price-yield
curve), the linear tangent is the bond's duration, which is shown in red on the graph below.
The exact point where the two lines touch represents Macaulay duration.

Modified duration measures the sensitivity of changes in bond price with changes in yield.
But modified duration does not account for large changes in price. If we were to use duration
to estimate the price resulting from a significant change in yield, the estimation would be
inaccurate. The yellow portions of the graph show the ranges in which using duration for
estimating price would be inappropriate.

Furthermore, as yield moves further from Y*, the yellow space between the actual bond price
(the blue line) and the prices estimated by duration (tangent red line) increases.

The convexity calculation, therefore, accounts for the inaccuracies of the linear duration
line and it shows how much a bond's yield changes in response to changes in price.

Properties of Convexity
Convexity is also useful for comparing bonds. If two bonds offer the same duration and yield
but one exhibits greater convexity, changes in interest rates will affect each bond differently.
A bond with greater convexity is less affected by interest rates than a bond with less
convexity. Also, bonds with greater convexity will have a higher price than bonds with a
lower convexity, regardless of whether interest rates rise or fall. This relationship is
illustrated in the following diagram:

Bond A has greater convexity than Bond B, but they both have the same price and convexity
when price equals *P and yield equals *Y. If interest rates change from this point by a very
small amount, then both bonds would have approximately the same price, regardless of the
convexity. When yield increases by a large amount, however, the prices of both Bond A and
Bond B decrease, but Bond B's price decreases more than Bond A's. Notice that at **Y the
price of Bond A remains higher than that of Bond B.

Factors Affecting Convexity

1) The graph of the price-yield relationship for a straight bond exhibits positive convexity. The
price-yield curve will increase as yield decreases, and vice versa. Therefore, as market yields
decrease, the duration increases (and vice versa).

2) In general, the higher the coupon rate, the lower the convexity of a bond. Zero-coupon bonds
have the highest convexity. A lower coupon bond has relatively more of its cash flows coming
at maturity rather than in periodic payments. Cash flows that come at later times have more
convexity.
3) Callable bonds will exhibit negative convexity at certain price-yield combinations. Negative
convexity means that as market yields decrease, duration decreases as well.

For callable bonds, modified duration can be used for an accurate estimate of bond price when
there is no chance that the bond will be called. In the chart above, the callable bond will
behave like an option-free bond at any point to the right of *Y. This portion of the graph has
positive convexity because, at yields greater than *Y, a company would not call its bond issue.
A bond issuer would find it most optimal, or cost-effective, to call the bond when prevailing
interest rates have declined below the callable bond's interest (coupon) rate. For yields
below *Y, the graph has negative convexity, as there is a higher possibility that the bond
issuer will call the bond.

Therefore, at yields below *Y, the price of a callable bond will not rise as much as the price of
a straight bond.

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