What Is Convexity?

Convexity is the curvature in the connection between bond prices and interest rates. It reflects the rate at which the duration of a bond changes as interest rates change. It's a way to depict risk/reward relationships in the bond market, as rates are presumably tied to prospective risk.

How Convexity Works

Convexity demonstrates how the duration of a bond changes as the interest rate changes. Portfolio managers will use convexity as a risk management tool to measure and manage the portfolio’s exposure to 澳洲幸运5官方开奖结果体彩网:interest rate risk.

In the example figure shown below, Bond A has a higher convexity than Bond B, which indicates that, all el🙈se being equal, Bond A will always have a higher p𓆏rice than Bond B as interest rates rise or fall.

As 🌱interest rates fall, bond prices rise. Conversely, rising market interest rates lead﷽ to falling bond prices.

The 澳洲幸运5官方开奖结果体彩网:bond yield is the earnings or returns an investor can expect to make by buying and holding that particular security. The bond price depends on several characteristics, including the 澳洲幸运5官方开奖结果体彩网:market interest rate, and can change regularly.

If market rates rise, new bond issues must also have higher rates to satisfy investor demand for le🦂nding money. The price of bonds returning less than that rate will fall, as there would be very little demand for them, as bondholders will look to sell their existing bonds and opt for bonds with hiౠgher yields.

Eventually, the price of these bonds with the lower coupon ♐rates will drop to a le꧅vel where the rate of return is equal to the prevailing market interest rates.

Bond Duration

澳洲幸运5官方开奖结果体彩网:Bond duration measures the change in a bond’s price when interest rates fluctuate. If the duration of a bond is high, it me🔯ans the bond’s price will move to a greater ♌degree in the opposite direction of interest rates.

If rates rise by 1%, a bond or bond fund🧜 with a five-year average duration would likely lose approximately 5% of its value. Conversely, when this figure is low, the debt instrument will show less movement to the change in interest rates.

The higher a bond’s duration, the larger the change in its price when interest rates ♉change, and the greater its interest rate risk. If an investor believes that interest♔ rates are going to rise, they should consider bonds with a lower duration.

Bond duration should not be confused with its 澳洲幸运5官方开奖结果体彩网:term to maturity. Though they both decline as the maturity date approaches, the latter is simply a measure of the time during which the bondholder will receive coupon payments until the principal is pa❀id.

If market rates rise b💮y 1%, a one-year maturity bond price should decline by an equal 1%. For bonds with long-dated maturities, the reaction increases. As a general rule of thumb, if rates rise by 1%, bond prices fall by 1% for each year of maturity.

Convexity and Risk

Convexity builds on the concept of duration by measuring the sensitivity of the duration of a bond as yields change. Convexity is a better 澳洲幸运5官方开奖结果体彩网:measure of interest rate risk. Where duration assumes that interest rates an🐈d bond prices have a linear relationship, convexity pr✃oduces a slope.

Duration can be a good measure of how b🙈ond prices may be affected due to small and sudden fluctuations in interest rates.

However, the relationship between bond prices and yields is typically more sloped or convex. Therefore, convexity is a better measure for assessing th🌄e impact on bond prices when there are large fluctuations in interest rates.

As convexity increases, the 澳洲幸运5官方开奖结果体彩网:systemic risk to which the portfolio is exposed increases. For a fixed-income portfolio, as interest rates rise, the 🅘existing fixed-rate instruments are not as attractive.

As convexity decreases, the exposure to market interest rates decreases, and the bond portfolio can be considered hedged. Typically, the higher the 澳洲幸运5官方开奖结果体彩网:coupon rate or yi🍸eld, the lower the convexiඣty or market risk of a bond.

Example of Convexity

A bond issuer, XYZ Corp., has two bonds on the market: Bond A and Bond B.ꦫ Both bonds have a face value of $100,000 and a coupon rate of 5%. Bond A, however, matures in five years, while Bond B matures in 10 years.

Using the concept of duration, we can calculate that Bond A has a duration of four years while Bond B has a duratio💧n of 5.5 years. This means that for♓ every 1% change in interest rates, Bond A’s price will change by 4% while Bond B’s price will change by 5.5%.

If the interest rate increases by 2%, the price of Bond A should decrease by 8%, w♎hile the price of Bond B will decrease by 11%. However, using the concept of convexity, we can predict that the price change for Bond B will be less than expected based on its duration alone.

This is because Bond🌊 B has a longeꦓr maturity, which means it has a higher convexity. The higher convexity of Bond B acts as a buffer against changes in interest rates, resulting in a relatively smaller price change than expected based on its duration alone.

Negative and Positive Convexity

If a bond’s duration increases as yields increase, the bond is said to have negative convexity. The bond price will decliꦕne by a greater rate with a rise in yields than if yields had fallen. Therefore, if a bond has negative convexity, its duration would increase, and the price would fall. As interest rates rise, the opposite is true.

If a bond’s duration rises and yields falꦬl, the bond is said to have positive convexity. As yields fall, bond prices rise by a greater rate or duration than if yields rise.

Positive convexity leads to increases in bond prices. If a bond has positive convexity, it would tᩚᩚᩚᩚᩚᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ𒀱ᩚᩚᩚypically experience price increases as yields fall, compared with price decreases when yields increase.

Under normal market conditions, the higher the coupon rate or yield, the lower a 澳洲幸运5官方开奖结果体彩网:bond’s degree of convexity. There’s less risk to the investor when the bond has a high coupon or yield, since marke🍒t rates would have to ♚increase significantly to surpass the bond’s yield.

A portfolio of bonds with high yields would have low conve🥂xity and, subsequently, less risk of existing yields becoming unattractive as interest rates rise.

Explain Like I'm 5

Convexity measures how a bond's price reacts when interest rates change. When interest rates go up, a bond's price goes down, and vice versa. The relationship is inverse. Convexity measures exactly how sensitive, whether more or less, a bond's price is when interest rates change.

Convexity is useful for investors who want to know how risky a bond might be if rates change. While duration gives you an estimate on how much the price may change, convexity will show you how much that estimate might change when rates are shifting more than expected. It's a much more holistic picture of a bond's movement given the interest rate environment.

How Will I Use This in Real Life?

Understanding convexity will allow you to be a better investor, matching your investment goals with the right assets. Depending on whether you want bonds that react more intensely or less dramatically to interest rate c𓄧hanges, convexity can help you invest in bonds that are right for your risk profile⭕.

Overall, understanding convexit🦄y will help you manage your portfolio better, detail how much exposure you have to rate changes in the economy, and keep you abreast of how your portfolio will react.

The Bottom Line

Convexity is a measure of the curvature of its duration or the relationship betweenไ bond prices and yields. It describes how the durat💖ion of a bond changes in response to changes in interest rates.

Convexity can impact the value of investments. Several factors impact the convexity of a bond, including the bond’s coupon rate, maturity, and credit quality. Bond invest๊ors can ൲use convexity to their advantage by managing their bond portfolios to take advantage of changes in interest rates.