Infinance,bond convexity is a measure of the non-linear relationship of bond prices to changes ininterest rates, and is defined as thesecond derivative of the price of the bond with respect to interest rates (duration is the first derivative). In general, the higher the duration, 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 ofconvexity in finance. Convexity was based on the work of Hon-Fei Lai and popularized by Stanley Diller.^[1]

Duration is alinear 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 curvedfunction 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.^[2]

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.^[3] 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 firstderivative 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.^[2]

Convexity does not assume the relationship between Bond value and interest rates to be linear.^[4] 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.^[5]

The price sensitivity to parallel changes in the term structure of interest rates is highest with azero-coupon bond and lowest with anamortizing bond (where the payments are front-loaded).^[6] 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 identicalbond durations then they will have identical sensitivities.^[7] 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 eachfurther incremental parallel rate shift due to their differing payment dates and amounts.^[8]

For two bonds with the same par value, coupon, and maturity, convexity may differ depending on what point on the price yield curve they are located.^[9]

If the flat, continuously compounded yield is${\displaystyle r}$ and the bond price is${\displaystyle B(r)}$, then convexity is defined as^[10]$${\displaystyle C(r)=\frac{1}{B(r)}\frac{{\mathrm{d}}^{2}B(r)}{\mathrm{d}{r}^2}.}$$

It is often convenient to express convexity via the modified duration. Define the modified duration by$${\displaystyle D(r)=-\frac{1}{B(r)}\frac{\mathrm{d}B(r)}{\mathrm{d}r}.}$$Equivalently,$${\displaystyle \frac{\mathrm{d}B(r)}{\mathrm{d}r}=-D(r)B(r).}$$

Differentiating the identity${\displaystyle \frac{\mathrm{d}B}{\mathrm{d}r}=-D(r)B(r)}$ gives$${\displaystyle \frac{{\mathrm{d}}^{2}B(r)}{\mathrm{d}{r}^2}=-\frac{\mathrm{d}D(r)}{\mathrm{d}r}B(r)-D(r)\frac{\mathrm{d}B(r)}{\mathrm{d}r}=(D(r{)}^2-\frac{\mathrm{d}D(r)}{\mathrm{d}r})B(r).}$$

Therefore,$${\displaystyle C(r)=\frac{1}{B(r)}\frac{{\mathrm{d}}^{2}B(r)}{\mathrm{d}{r}^2}=D(r{)}^2-\frac{\mathrm{d}D(r)}{\mathrm{d}r}.}$$

Here${\displaystyle D(r)}$ denotes the modified duration defined above.

For yields quoted with periodic (discrete) compounding at rate${\displaystyle y}$ per period, the modified duration is:^[11]$${\displaystyle D(y)=\frac{1}{1+y}\sum _{i=1}^n\frac{P_i{t}_i}{B}.}$$Here${\displaystyle P_i}$ is thepresent value of cash flow${\displaystyle i}$, and${\displaystyle t_i}$ is its payment time.

As theinterest rate increases, the present value of longer-dated payments declines in relation to earlier coupons (by thediscount factor between the early and late payments).^[12] 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 inr must decrease the duration (or, in the case of zero-coupon bonds, leave the unmodified duration constant).^[13][14] Note that the modified durationD differs from the regular duration by the factor one over1 + r (shown above), which also decreases asr is increased.

$${\displaystyle \frac{\mathrm{d}D(r)}{\mathrm{d}r}\le 0.}$$

From the identity above, convexity is positive for option-free bonds.^[15]

Convexity is positive for option-free bonds. Under a flat, continuously compounded curve,$${\displaystyle B(r)=\sum _{i=1}^n{c}_i{\mathrm{e}}^{-r{t}_i}.}$$Differentiating twice,$${\displaystyle \frac{{\mathrm{d}}^{2}B(r)}{\mathrm{d}{r}^2}=\sum _{i=1}^n{c}_i{t}_i^2{\mathrm{e}}^{-r{t}_i}\ge 0,}$$hence${\displaystyle C(r)=\frac{1}{B(r)}\frac{{\mathrm{d}}^{2}B(r)}{\mathrm{d}{r}^2}\ge 0}$.

For duration, define present-value weights

${\displaystyle w_i={\displaystyle \frac{c_i{\mathrm{e}}^{-r{t}_i}}{B(r)}}}$ (so${\displaystyle \sum _{i=1}^n{w}_i=1}$).

Then${\displaystyle D(r)=\sum _{i=1}^n{w}_i{t}_i}$, and$${\displaystyle \frac{\mathrm{d}D(r)}{\mathrm{d}r}=-\sum _{i=1}^n{w}_i(t_i-D(r){)}^2\le 0,}$$with equality only for a single cash flow (a zero-coupon bond).

Convexity and duration are standard one-factor risk measures for parallel shifts in the yield curve. Duration controls the first-order price sensitivity and convexity the second-order term; together they are used to estimate and hedge interest-rate risk. A portfolio is first-order hedged when its (dollar) duration is close to zero versus a benchmark; adding a convexity match reduces second-order exposure for larger shifts.^[16][17]

For a small parallel yield changeΔy, the second-order Taylor approximation of price is$${\displaystyle \frac{\mathrm{\Delta }B}{B}\approx -D\mathrm{\Delta }y+\frac{1}{2}C(\mathrm{\Delta }y{)}^2,}$$or, in dollar terms,$${\displaystyle \mathrm{\Delta }B\approx -BD\mathrm{\Delta }y+\frac{1}{2}BC(\mathrm{\Delta }y{)}^2.}$$These formulae are standard and underpin duration- and convexity-based hedging.^[18]

For portfolios with the same duration, higher convexity (e.g., a “barbell” of short- and long-dated bonds versus a “bullet” concentrated near one maturity) improves second-order behaviour: gains when yields fall are larger than losses when yields rise of the same size.^[19]

For bonds withembedded options, price depends on how theyield curve move alters expected cash flows viaoption exercise. Standard, yield-to-maturity-based duration and convexity assume fixed cash flows and so miss this effect. In such cases, effective convexity is obtained numerically.^[20]

Effective convexity is a centredfinite difference approximation to thesecond derivative of price with respect to the yield level:^[20]

$${\displaystyle \text{Effective convexity}=\frac{V_{-\mathrm{\Delta }y}-2V_0+V_{+\mathrm{\Delta }y}}{V_0(\mathrm{\Delta }y{)}^2}.}$$

Here${\displaystyle V}$ is the model price (from anoption-pricing framework),${\displaystyle \mathrm{\Delta }y}$ is the size of a parallel shift in the curve, and${\displaystyle V_{-\mathrm{\Delta }y}}$ and${\displaystyle V_{+\mathrm{\Delta }y}}$ are the corresponding prices when yields fall or rise by${\displaystyle \mathrm{\Delta }y}$, respectively.

In practice the prices${\displaystyle V_{-\mathrm{\Delta }y}}$,${\displaystyle V_0}$ and${\displaystyle V_{+\mathrm{\Delta }y}}$ are computed from an interest-rate model that re-values the whole curve and the option at each node (for example, a short-rate lattice - seeLattice model (finance)#Interest rate derivatives).^[21][22]

• Black–Scholes equation
• Bond duration
• Bond valuation
• Fixed-income attribution § First principles versus perturbational attribution
• Immunization (finance)
• List of convexity topics
• List of finance topics

• Frank Fabozzi,The Handbook of Fixed Income Securities, 7th ed., New York: McGraw Hill, 2005.
• Fabozzi, Frank J. (1999). "The basics of duration and convexity".Duration, Convexity, and Other Bond Risk Measures. Frank J. Fabozzi Series. Vol. 58. John Wiley and Sons.ISBN 9781883249632.
• Mayle, Jan (1994),Standard Securities Calculation Methods: Fixed Income Securities Formulas for Analytic Measures, vol. 2 (1st ed.),Securities Industry and Financial Markets Association,ISBN 1-882936-01-9. The standard reference for conventions applicable to US securities.

• The Investment Fund For Foundations explains the dangers of buying high-negative-convexity bonds
• Video tutorial, Bond duration and convexity explained
• Investopedia convexity explanation

• Fixed income analysis
• Bond valuation

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