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  • Convexity Calculation

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    Rabeya Aktar
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    The document discusses convexity and its relationship to interest rate risk for bonds. It explains that bonds with higher convexity values experience smaller price fluctuations when interest rates change, resulting in lower interest rate risk. Conversely, bonds with lower convexity are more sensitive to interest rate changes and have higher potential for price losses. The document provides formulas for calculating dollar convexity and convexity, and demonstrates their use for two sample bonds.

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    The document discusses convexity and its relationship to interest rate risk for bonds. It explains that bonds with higher convexity values experience smaller price fluctuations when interest rates change, resulting in lower interest rate risk. Conversely, bonds with lower convexity are more sensitive to interest rate changes and have higher potential for price losses. The document provides formulas for calculating dollar convexity and convexity, and demonstrates their use for two sample bonds.

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    21 views7 pages

    Convexity Calculation

    Uploaded by

    Rabeya Aktar
    The document discusses convexity and its relationship to interest rate risk for bonds. It explains that bonds with higher convexity values experience smaller price fluctuations when interest rates change, resulting in lower interest rate risk. Conversely, bonds with lower convexity are more sensitive to interest rate changes and have higher potential for price losses. The document provides formulas for calculating dollar convexity and convexity, and demonstrates their use for two sample bonds.

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    of 7

    Convexity Calculation

    Interpretation of Convexity Values

    Higher Convexity and Lower Interest Rate Risk


     Bonds with higher convexity values are less sensitive to interest rate changes, offering lower
    interest rate risk.
     Higher convexity indicates that the bond's price will experience smaller fluctuations in response
    to interest rate shifts, providing a cushion against rate changes.
    Lower Convexity and Higher Interest Rate Risk
     Bonds with lower convexity values are more sensitive to interest rate changes, exposing
    investors to higher interest rate risk.
     Lower convexity suggests that the bond's price will experience larger fluctuations in response to
    interest rate shifts, increasing the potential for losses.
     Dollar Convexity : t*(t+1)*Cf/(1+y)^(t+2)
    Bond  Convexity : [t*(t+1)*Cf/(1+y)^(t+2)]/p
    Coupon Rate 7%
    Par Value 1000
    Years Mat 4
    YTM 3%

    Macaulay Dollar Convexity


    Duration (4)
    Time (1) Cash Flow (2) PV of Cash Flows
    =
    (1)x(3)/Price Conv
    1Coupon 70 67.96117 0.059164 128.120 128.1198323 0.111536192
    2 70 65.98171 0.114882 373.165 373.1645601 0.324862696
    Bond A 3 70 64.05992 0.167304 724.591 724.5913789 0.630801351
    Coupon +
    4 Principal 1070 950.68114 3.310506 17922.163 17922.16309 15.60234502
    1148.68394 3.651857 19148.039 19148.03886 16.66954526 16.66954526
    Bond B 4Principal 1000 888.48705 4 16749.685 18.85191818

    Modified Change in Bond Price Δp = Δy Change in Bond Price Δp = Δy


    Macaulay x (4) x (4) + 0.5*(7)*Δy2
    Duration Dollar Covexity
    Bond (1) Duration Convexity (7)
    (3) = (6)
    (2) Dollar Duration Δy = .005 Δy = .02 Δy = .005 Δy = .02
    (2)/(1+y)
    (4) = -P*(3)
    A 3.6519 3.5455 -4072.6494 -20.3632 -81.4530 19148.039 16.6695 -20.1239 -77.6234
    B 4.0000 3.8835 -3450.4351 -17.2522 -69.0087 16749.685 18.8519 -17.0428 -65.6588
     Dollar Convexity : t*(t+1)*Cf/(1+y)^(t+2)
     Convexity : [t*(t+1)*Cf/(1+y)^(t+2)]/p

    https://www.wallstreetmojo.com/convexity-of-a-bond-formula-duration/
     If the only modified duration is used:
     Change in price = – Modified Duration *Change in yield
     Change in price for 1% increase in yield = ( – 4.59*1%) = -4.59%
     So the price would decrease by 41.83
     To accommodate the convex shape of the graph, the change in price formula changes to:
     Change in price = [–Modified Duration *Change in yield] +[1/2 * Convexity*(change
    in yield)2]
     Change in price for 1% increase in yield = [-4.59*1 %] + [1/2 *26.2643* 1%] = -4.46%
     So the price would decrease by only 40.64 instead of 41.83
     This shows how, for the same 1% increase in yield, the predicted price decrease changes
    if the only duration is used as against when the convexity of the price yield curve is also
    adjusted.
    A 8%, 7 year coupon bond and a zero. The YTM is 12%.
    1. Calculate the price of the bonds
    2. Calculate the Macaulay, Modified and dollar duration of the bonds.
    3. If the price changes by 1% then what will be the new price?
    4. Do you think the price change calculated by duration is accurate? If not then calculate the corrected price change.

    Bond
    Coupon Rate 8%
    Par Value 1000
    Years Mat 7
    YTM 12%

    Macaulay Dollar Convexity


    Time (1) Cash Flow (2) PV of Cash Flows Duration (4)
    = Conv
    1Coupon 80 71.42857 0.087380 113.885 113.8848 0.139317238
    2Coupon 80 63.77551 0.156035 305.049 305.0487 0.373171173
    3Coupon 80 56.94242 0.208976 544.730 544.7298 0.666377094
    4Coupon 80 50.84145 0.248781 810.610 810.6098 0.991632581
    Bond A
    5Coupon 80 45.39415 0.277657 1085.638 1085.638 1.328079349
    6Coupon 80 40.53049 0.297490 1357.048 1357.048 1.660099187
    Coupon +
    7 Principal 1080 488.53715 4.183450 21809.694 21809.69 26.6801655
    817.44974 5.459769 26026.653 26026.65 31.83884212 31.83884212
    Bond B 7 Principal 100 45.23492 7 2019.416 44.64285714

    Modified Dollar Duration Change in Bond Price Δp = Δy x Change in Bond Price Δp = Δy x Change in Bond Price Δp = Δy x
    Macaulay (4) (4) + 0.5*(6)*Δy2 (3) + 0.5*(7)*Δy2
    Duration Dollar Covexity Convexity
    Bond (1) Duration
    (3) = (6) (7)
    (2) Δy = .005 Δy = .01 Δy = .005 Δy = .01 Δy = .005 Δy = .01
    (2)/(1+y) (4) = -P*(3)
    A 5.4598 4.8748 -3984.8986 -19.9245 -39.8490 26026.653 31.8388 -19.5992 -38.5477 2.48% 5.034%
    B 7.0000 6.2500 -282.7183 -1.4136 -2.8272 2019.416 44.6429 -1.3883 -2.7262 3.18% 6.473%

    797.52525 797.85058 797.1999

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