In finance, convexity is a measure of the sensitivity of the duration of a bond to changes in interest rates, the second derivative of the

price of the bond with respect to interest rates (duration is the first derivative). In general, the higher the convexity, the more sensitive the bond price is to the change in interest rates. Bond convexity is one of the most basic and widely-used forms of convexity in finance. Calculation of convexity Duration is a linear measure or 1st derivative of how the price of a bond changes in response to interest rate changes. As interest rates change, the price is not likely to change linearly, but instead it would change over some curved function of interest rates. The more curved the price function of the bond is, the more inaccurate duration is as a measure of the interest rate sensitivity. Convexity is a measure of the curvature or 2nd derivative of how the price of a bond varies with interest rate, i.e. how the duration of a bond changes as the interest rate changes. Specifically, one assumes that the interest rate is constant across the life of the bond and that changes in interest rates occur evenly. Using these assumptions, duration can be formulated as the first derivative of the price function of the bond with respect to the interest rate in question. Then the convexity would be the second derivative of the price function with respect to the interest rate.

In actual markets the assumption of constant interest rates and even changes is not correct, and more complex models are needed to actually price bonds. However, these simplifying assumptions allow one to quickly and easily calculate factors which describe the sensitivity of the bond prices to interest rate changes.

Why bond convexities may differ The price sensitivity to parallel changes in the term structure of interest rates is highest with a zero-coupon bond and lowest with an amortizing bond (where the payments are frontloaded). Although the amortizing bond and the zero-coupon bond have different sensitivities at the same maturity, if their final maturities differ so that they have identical bond durations they will have identical sensitivities. That is, their prices will be affected equally by small, first-order, (and parallel) yield curve shifts. They will, however, start to change by different amounts with each further incremental parallel rate shift due to their differing payment dates and amounts. For two bonds with same par value, same coupon and same maturity, convexity may differ depending on at what point on the price yield curve they are located. Suppose both of them have at present the same price yield (py) combination; also you have to take into consideration the profile, rating, etc. of the issuers: let us suppose they are issued by different entities. Though both bonds have same p-y

combination bond A may be located on a more elastic segment of the p-y curve compared to bond B. This means if yield increases further, price of bond A may fall drastically while price of bond B wont change, i.e. bond B holders are expecting a price rise any moment and are therefore reluctant to sell it off, while bond A holders are expecting further price-fall and ready to dispose of it. This means bond B has better rating than bond A. So the higher the rating or credibility of the issuer the less the convexity and the less the gain from risk-return game or strategies; less convexity means less price-volatility or risk; less risk means less return.

Mathematical definition If the flat floating interest rate is r and the bond price is B, then the convexity C is defined as

Another way of expressing C is in terms of the modified duration D:

Therefore

leaving

Where D is a Modified Duration

How bond duration changes with a changing interest rate Return to the standard definition of modified duration:

where P(i) is the present value of coupon i, and t(i) is the future payment date. As the interest rate increases the present value of longer-dated payments declines in relation to earlier coupons (by the discount factor between the early and late payments). However, bond price also declines when interest rate increases, but changes in the present value of sum of each coupons times timing (the numerator in the summation) are larger than changes in the bond price (the denominator in the summation). Therefore, increases in r must decrease the duration (or, in the case of zero-coupon bonds, leave the unmodified duration constant). Note that the modified duration D differs from the regular duration by the factor one over 1+r (shown above), which also decreases as r is increased.

Given the relation between convexity and duration above, conventional bond convexities must always be positive. The positivity of convexity can also be proven analytically for basic interest rate securities. For example, under the assumption of a flat yield curve one can write the value of a

coupon-bearing bond as , where ci stands for the coupon paid at time ti. Then it is easy to see that

Note that this conversely implies the negativity of the derivative of duration by differentiating .

Application of convexity 1. Convexity is a risk management figure, used similarly to the way 'gamma' is used in derivatives risks management; it is a number used to manage the market risk a bond portfolio is exposed to. If the combined convexity and duration of a trading book is high, so is the risk. However, if the combined convexity and duration are low, the book is hedged, and little money will be lost even if fairly substantial interest movements occur. (Parallel in the yield curve.) 2. The second-order approximation of bond price movements due to rate changes uses the convexity:

Definition of 'Convexity'
A measure of the curvature in the relationship between bond prices and bond yields that demonstrates how the duration of a bond changes as the interest rate changes. Convexity is used as a risk-management tool, and helps to measure and manage the amount of market risk to which a portfolio of bonds is exposed.

Investopedia explains 'Convexity'

In the example above, Bond A has a higher convexity than Bond B, which means that all else being equal, Bond A will always have a higher price than Bond B as interest rates rise or fall. As convexity increases, the systemic risk to which the portfolio is exposed increases. As convexity decreases, the exposure to market interest rates decreases and the bond portfolio can be considered hedged. In general, the higher the coupon rate, the lower the convexity (or market risk) of a bond. This is because market rates would have to increase greatly to surpass the coupon on the bond, meaning there is less risk to the investor. Read more: http://www.investopedia.com/terms/c/convexity.asp#ixzz1pOPnXMPy

Definition of 'Bond'
A debt investment in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate. Bonds are used by companies, municipalities, states and U.S. and foreign governments to finance a variety of projects and activities. Bonds are commonly referred to as fixed-income securities and are one of the three main asset

classes, along with stocks and cash equivalents..

Investopedia explains 'Bond'

The indebted entity (issuer) issues a bond that states the interest rate (coupon) that will be paid and when the loaned funds (bond principal) are to be returned (maturity date). Interest on bonds is usually paid every six months (semi-annually). The main categories of bonds are corporate bonds, municipal bonds, and U.S. Treasury bonds, notes and bills, which are collectively referred to as simply "Treasuries". Two features of a bond - credit quality and duration - are the principal determinants of a bond's interest rate. Bond maturities range from a 90-day Treasury bill to a 30-year government bond. Corporate and municipals are typically in the three to 10-year range.

Definition of 'Yield'
The income return on an investment. This refers to the interest or dividends received from a security and is usually expressed annually as a percentage based on the investment's cost, its current market value or its face value.

Investopedia explains 'Yield'

This seemingly simple term, without a qualifier, can be rather confusing to investors. For example, there are two stock dividend yields. If you buy a stock for $30 (cost basis) and its current price and annual dividend is $33 and $1, respectively, the "cost yield" will be 3.3% ($1/$30) and the "current yield" will be 3% ($1/$33). Bonds have four yields: coupon (the bond interest rate fixed at issuance), current (the bond interest rate as a percentage of the current price of the bond), and yield to maturity (an estimate of what an investor will receive if the bond is held to its maturity date). Non-taxable municipal bonds will have a tax-equivalent (TE) yield determined by the investor's tax bracket. Mutual fund yields are an annual percentage measure of income (dividends and interest) earned by the fund's portfolio, net of the fund's expenses. In addition, the "SEC yield" is an indicator of the percentage yield on a fund based on a 30-day period. Read more: http://www.investopedia.com/terms/y/yield.asp#ixzz1pOQ28zl7

Definition of 'Negative Convexity'

When the shape of a bond's yield curve is concave. A bonds convexity is the rate of change of its duration, and is measured as the second derivative of price with respect to yield.

Most mortgage bonds are negatively convex.

Investopedia explains 'Negative Convexity'

Callable bonds are negatively convex at lower yields than the yield at which the bond is likely to be called. One property of a non-callable bond is that as interest rates fall, its price will increase. However, with a callable bond, as interest rates fall, the incentive for the issuer to call the bond at par increases; therefore, its price will not rise as quickly as the price of a non-callable bond. The price of a callable bond might actually drop as the likelihood that the bond will be called increases. This is why the shape of a callable bond's curve of price with respect to yield is concave or "negatively convex." Read more: http://www.investopedia.com/terms/n/negative_convexity.asp#ixzz1pOQG892h

Applet : Concavity / Convexity Test

Let (i) ( ii ) be a Function with first derivative for all x implies for all x implies and second derivative . Then ,

is strictly concave upward in (a, b). is strictly concave downward in (a, b). .

The point where concave upward changes to concave downward is called inflation point for The following applet helps you to check the above properties. To start the applet select a function /or enter your function and hit New Function. You can see the graph of & by checking the appropriate boxes. As you move the slider for x you can see the value of and .