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Bond Convexity Basics

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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 front-loaded). 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 (p-y) 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 won’t 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:

where ci stands for the coupon paid at time ti.) 2. (Parallel in the yield curve. it is a number used to manage the market risk a bond portfolio is exposed to. and little money will be lost even if fairly substantial interest movements occur. used similarly to the way 'gamma' is used in derivatives risks management. conventional bond convexities must always be positive. under the assumption of a flat yield curve one can write the value of a coupon- bearing bond as . 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). Then it is easy to see that Note that this conversely implies the negativity of the derivative of duration by differentiating . Given the relation between convexity and duration above. and t(i) is the future payment date. leave the unmodified duration constant). 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). For example. However.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. The second-order approximation of bond price movements due to rate changes uses the convexity: . However. which also decreases as r is increased. in the case of zero-coupon bonds. Therefore. the book is hedged. Convexity is a risk management figure. Application of convexity 1. bond price also declines when interest rate increases. if the combined convexity and duration are low. Note that the modified duration D differs from the regular duration by the factor one over 1+r (shown above). increases in r must decrease the duration (or. so is the risk. The positivity of convexity can also be proven analytically for basic interest rate securities. If the combined convexity and duration of a trading book is high.

For example. For example. the bond is more likely to subject to change in price due to a interest rate change. Interest Rate Risk . It is known that when interest rate goes up. the investor will likely choose the one with the higher coupon rate. However. it will not in anyway adversely affect a bond's investor. Interest rate may go up or down at different points in time for different reasons. a decrease in interest rate will lead to a decrease in future income of the bond investor. Reinvestment Rate Risk . Federick Macaulay conceived the idea of a measurement call the Duration to measure the Interest Rate Risk. ******** Bond Duration and Convexity Background. it causes a decrease in the price of a bond. A higher coupon rate allows the price of the bond to be recovered in a shorter time frame and thus expose an investor to less Interest Rate Risk. during a recession. With a longer time frame. The other factor affecting the Interest Rate Risk is the Coupon Rate. This risk of a decrease in income due to a decrease in interest rates is known as the Reinvestment Rate Risk. one with a 10 percent coupon rate and the other with a 5 percent coupon rate. Bond Duration: In 1938. The shorter time frame is considered good as it allows the investor to be less exposed to a risk known as the Interest Rate Risk. the coupon amount received by an investor can only be reinvested in lower yielding bonds. . From a returns perspective. interest rate will be cut to kick-start the economy. The risk of the decrease in the price of a bond due to an increase in the interest rate is known as the Interest Rate Risk. It combines the maturity of a bond and the coupon rate and can be thought of as how long it takes for the price of a bond to be recovered. the 10 percent coupon allows the investor to recoup his or her investment in a shorter time frame. We might think that since a decrease in interest rates lead to an increase in Bond Price. Assuming the risk of default is the same for the two bonds. One of the factors affecting the Interest Rate Risk is the maturity of a bond. When the economy recovers and exhibits behaviour of inflation. If an investor is given a choice of two 10-year bonds to choose from. the interest rate may increase. The reverse where interest rate goes down causing an increase in bond price is also true.

On top of that. Modified Duration is calculated as follows: Modified Duration = Macaulay Duration / (1 + (Current Yield to Maturity/Number of Payments in a year)) Bond Convexity: Modified Duration can be used to approximate the price change of a bond in a linear manner as shown in the formula above. It is important to note that the degree of the "curvature" of the curve is known as the convexity. if we assume two bonds will provide the same duration and yield then the bond with the greater convexity will be less affected by interest rate change. the lesser the price drop when interest rate increase. The relationship is actually curvilinear. How to use the Bond Convexity: Bond Convexity is defined formally as the degree to which the duration changes when the yield to maturity changes. Bond Market Price . It can be used to account for the inaccuracies of the Modified Duration approximation. This is the approximation of the percentage change in the price of the bond to the percentage change in yield.The present value of the cash flow is discounted using the Yield to Maturity.The present value of all cash flows of the bond. If the number of years to maturity is 10 then t is 1 to 10. The diagram below shows the approximation using Modified Duration as a straight line and the actual price-interest rate change relationship as a curve. In fact. The basic assumptions are that the bond is not tied to any Options and changes in yields are small.Macaulay Duration: Macaulay Duration can be calculated as follows: Duration = Sum ((Present Value of Cash Flow at Time t * t) / Bond Market Price) t . Bond Duration and Convexity Spreadsheet The "Bond Duration" worksheet allows you to calculate the Duration of a bond quickly and easily. the price and change in interest rate change relationship is not exactly linear. Present Value of Cash Flow at Time t . .the time period of the cash flow. Modified Duration: One of the interesting side effects of Macaulay Duration is that it can be adjusted to approximate the interest rate sensitivity of a bond. This can be easily visualized from the diagram above where the greater the "curvature".

the coupon payments is equivalent to : (Coupon Rate / 2) * Face Value of the Bond Face Value (F) .This field is related to the Coupon Payment Frequency.The current price of the bond in the market.This is the stated annual interest rate payments for a Bond. The coupon rate is typically stated in an annual percentage. Thus if a coupon is paid out semi-annually. they typically refer to the Annual Percentage Rate.This field indicates whether the coupon is paid annually or semi- annually. If Coupon Payment Frequency is set to Annually. Bond Price (v) . The Effective Annual Rate basically takes into account the effect of compounding interests of the coupons. .The principal or loan amount of the bond to be repaid at the end of the maturity period. This field is used in the calculation of the Bond's Yield to Maturity. Bond prices fluctuates due to changes in interest rates and the price that the bond is purchased affects the Yield to Maturity. When people talk about yield to maturity. then Number of Periods means number of One-year period.This Bond Valuation spreadsheet distinguishes between the Annual Percentage Rate and the Effective Annual Rate. Number of Periods means number of Half-year period. Coupon Rate (I) .Input Values Coupon Payment Frequency (pf) . Number of Periods to Maturity (N) . Yield to Maturity Type . If Coupon Payment Frequency is set to Semi-Annually. This interest rate multiply with the Face value gives the periodic coupon payments.

if the Coupon Payment Frequency is semi-annually. For example. In the spreadsheet it is calculated as follows: Duration = Sum ((Present Value of Cash Flow at Time t * t) / Bond Market Price) The Bond Market Price is calculated as the sum of the values in the column "PV of Cash Flows". The composite measure of interest rate sensitivity of a bond. then this discount rate is the rate per six months. Input Values: The following three input fields (which are explained in this document above) are used for calculating the Modified Duration: Coupon Payment Frequency Yield to Maturity (Y) Duration The Percentage Change in Yield field is an input value for the calculation of the "Percentage Change in the price of the Bond". Duration . .Output Values Discount Rate per period (r) .Adjusted Macaulay Duration. This discount rate is the exact rate per period. The price change is estimated using the Modified Duration.Adjusted Macaulay Duration.This is calculated as (-(Modified Duration)/(1+Y)) * (Percentage Change in Yield). Convexity .The degree to which the duration changes when the yield to maturity changes. Modified Duration . It is calculated as Macaulay Duration divided by 1 + yield to maturity. It is calculated as Macaulay Duration divided by 1 + yield to maturity. Output Values: Modified Duration . Percentage Change in the price of the Bond .Yield to Maturity is typically quoted like an Annual Percentage Rate. The formula for calculating bond convexity is shown below. Also known as the Modified Duration.Macaulay Duration. Convexity = (Sum(PV*(t^2+t))/((1+Discount Rate per period)^2))/Bond Market Price Estimating price change using the Modified Duration The "Using Modified Bond Duration" worksheet can be used for estimating the price change of a bond when there is a change in Yield. The column "(PV*(t^2+t))" is used for calculating the Convexity of the Bond. Also known as the Modified Duration.

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