Bond Convexity: The Relationship Between Price and Yield
Last week we discussed bond duration. This week, we're talking convexity.
If you didn't read the duration piece, please go back and do so. I'm going to rely heavily on it in this piece.
Last week, we talked about how you can use duration to estimate how much the price of a bond will change if its yield changes. In the example we used, a bond with a duration of 6.4 years will go up about 6.4% in price if its yield drops by 1% (100 basis points), and down about 6.4% in price if its yield rises by 100 basis points.
If duration describes the approximate relationship between price and yield, convexity describes the actual relationship between price and yield.Take a look at this graph. For now, just concentrate on the red line, which describes the relationship between price and yield for a standard, noncallable bond. (We'll get to callable bonds in a little bit.)
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