Convexity Adjustment

DEFINITION of 'Convexity Adjustment'

The change required to be made to a forward interest rate or yield to get the expected future interest rate or yield. Convexity adjustment refers to the difference between the forward interest rate and the future interest rate; this difference has to be added to the former to arrive at the latter. The need for this adjustment arises because of the non-liner relationship between bond prices and yields.

BREAKING DOWN 'Convexity Adjustment'

An adjustment for convexity is often necessary when pricing bonds, interest rate swaps and other derivatives. This adjustment is required because of the unsymmetrical change in the price of a bond in relation to changes in interest rates or yields. In other words, the percentage increase in the price of a bond for a defined decrease in rates or yields, is always more than the decline in the bond price for the same increase in rates or yields. A number of factors influence the convexity of a bond, including its coupon rate, duration, maturity and current price.

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