Convexity

Loading the player...

What is 'Convexity'

Convexity is a measure of the curvature in the relationship between bond prices and bond yields that demonstrates how the duration of a bond changes as the interest rate changes. Convexity is used as a risk-management tool, and helps to measure and manage the amount of market risk to which a portfolio of bonds is exposed.

 

convexity2.gif

BREAKING DOWN 'Convexity'

In the example above, Bond A has a higher convexity than Bond B, which means that all else being equal, Bond A will always have a higher price than Bond B as interest rates rise or fall.

As convexity increases, the systemic risk to which the portfolio is exposed increases. As convexity decreases, the exposure to market interest rates decreases and the bond portfolio can be considered hedged. In general, the higher the coupon rate, the lower the convexity (or market risk) of a bond. This is because market rates would have to increase greatly to surpass the coupon on the bond, meaning there is less risk to the investor.

RELATED TERMS
  1. Negative Convexity

    When the shape of a bond's yield curve is concave. A bond's convexity ...
  2. Convexity Adjustment

    The change required to be made to a forward interest rate or ...
  3. Bond

    A debt investment in which an investor loans money to an entity ...
  4. Bond Option

    An option contract in which the underlying asset is a bond. Other ...
  5. Discount Bond

    A bond that is issued for less than its par (or face) value, ...
  6. Required Yield

    The return a bond must offer in order to be a worthwhile investment. ...
Related Articles
  1. Bonds & Fixed Income

    Explaining Convexity

    Convexity is the measure of the curve in the relationship between a bond’s price and its yield.
  2. Bonds & Fixed Income

    Advanced Bond Concepts: Conclusion

    You have now learned some of the more advanced topics associated with bonds. Let's run through a quick recap of what we discussed in this tutorial: Bonds vary according to characteristics ...
  3. Options & Futures

    Immunization Inoculates Against Interest Rate Risk

    Big-money investors can hedge against bond portfolio losses caused by rate fluctuations.
  4. Economics

    The Effect of Fed Fund Rate Hikes on Your Bond Portfolio

    Learn how an increase in the federal funds rate may impact a bond portfolio. Read about how investors can use the duration of their portfolio to reduce risk.
  5. Bonds & Fixed Income

    How To Invest In Corporate Bonds

    Understand the basics of corporate bonds to increase your chances of positive returns.
  6. Bonds & Fixed Income

    Understanding Interest Rates, Inflation And Bonds

    Get to know the relationships that determine a bond's price and its payout.
  7. Mutual Funds & ETFs

    Key Strategies To Avoid Negative Bond Returns

    It is difficult to make money in bonds in a rising rate environment, but there are ways to avoid losses.
  8. Products and Investments

    How Rising Rates Impact Bond Mutual Funds

    The interest rate increase by the Fed was one of the most widely anticipated in history. Here's what it means for bond mutual funds.
  9. Bonds & Fixed Income

    Risks To Consider Before Investing In Bonds

    Make sure you understand the risks associated with bonds before making an investment decision.
  10. Home & Auto

    How To Choose The Right Bond For You

    Bond investing is a stable and low-risk way to diversify a portfolio. However, knowing which types of bonds are right for you is not always easy.
RELATED FAQS
  1. You currently are holding a portfolio of bonds. Interest rates are expected to increase ...

    The correct answer is c. Bonds with high convexity are less affected by changes in interest rates than bonds with lower convexity. ... Read Answer >>
  2. Do long-term bonds have a greater interest rate risk than short-term bonds?

    The answer to this question lies in the fixed income nature of bonds and debentures, often referred to together simply as ... Read Answer >>
  3. Which factors most influence fixed income securities?

    Learn about the main factors that impact the price of fixed income securities, and understand the various types of risk associated ... Read Answer >>
  4. How does duration impact bond funds?

    Learn how duration for a bond fund measures the risk the bond portfolio has to a rise in interest rates, and see how managers ... Read Answer >>
  5. Why is my bond worth less than face value?

    Find out how bonds can be issued or traded for less than their listed face values, and learn what causes bond prices to fluctuate ... Read Answer >>
  6. What are the risks of investing in a bond?

    The most well-known risk in the bond market is interest rate risk - the risk that bond prices will fall as interest rates ... Read Answer >>
Hot Definitions
  1. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  2. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  3. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  4. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
  5. Sharing Economy

    An economic model in which individuals are able to borrow or rent assets owned by someone else.
  6. Unlevered Beta

    A type of metric that compares the risk of an unlevered company to the risk of the market. The unlevered beta is the beta ...
Trading Center