1

There are no permanent changes because

change itself is permanent. It behooves the
industrialist to research and the investor to
be vigilant.

- Ralph L. Woods
 Bond Convexity
2

The importance of convexity

Calculating convexity
General rules of convexity
Using convexity
 The Importance of Convexity
3

Convexity is the difference between the actual

price change in a bond and that predicted by the
duration statistic

In practice, the effects of convexity are minor

 The Importance
of Convexity (cont’d)
4

The first derivative of price with respect to yield is

negative
 Downward sloping curves
The second derivative of price with respect to yield is
positive
 The decline in bond price as yield increases is decelerating
 The sharper the curve, the greater the convexity
 The Importance
of Convexity (cont’d)
5

Greater Convexity
Bond Price

Yield to Maturity
 The Importance
of Convexity (cont’d)
6

As a bond’s yield moves up or down, there is a

divergence from the actual price change (curved line)
and the duration-predicted price change (tangent
line)
 The more pronounced the curve, the greater the price
difference

 The greater the yield change, the more important convexity

becomes
 The Importance
of Convexity (cont’d)
7

Bond Price

Error from using

duration only

Current bond
price

Yield to Maturity
 Calculating Convexity (cont’d)
8

Modified duration is calculated as follows:

Macaulay duration
Modified duration =
1 + ( Annual yield to maturity / 2) 
 General Rules of Convexity
9

There are two general rules of convexity:

 The higher the yield to maturity, the lower the convexity,
everything else being equal

 The lower the coupon, the greater the convexity, everything

else being equal
 Using Convexity
10

Given a choice, portfolio managers should seek

higher convexity while meeting the other constraints
in their bond portfolios
 They minimize the adverse effects of interest rate volatility for
a given portfolio duration