Economics Bonds Questions Medium
Bond convexity is a measure of the sensitivity of a bond's price to changes in interest rates. It is a measure of the curvature of the relationship between bond prices and yields. Convexity takes into account the fact that the relationship between bond prices and yields is not linear, but rather exhibits a curved shape.
Convexity is important because it helps investors understand the potential price changes of a bond when interest rates fluctuate. It provides a more accurate estimate of the bond's price change compared to just using duration, which only considers the linear relationship between bond prices and yields.
When interest rates decrease, bond prices generally increase, and when interest rates increase, bond prices generally decrease. However, the relationship is not perfectly linear. Convexity captures the fact that as interest rates change, the percentage price change of a bond is not symmetrical. In other words, when interest rates decrease, the bond price increases by a greater percentage than when interest rates increase by the same amount.
Convexity is particularly relevant for bonds with longer maturities and lower coupon rates, as they tend to have higher convexity values. This means that these bonds are more sensitive to changes in interest rates and their prices are likely to change more compared to bonds with lower convexity.
Investors can use convexity to manage interest rate risk in their bond portfolios. By understanding the convexity of their bonds, investors can make more informed decisions about the potential impact of interest rate changes on their portfolio's value.