Question

Which of following statement/s is/are false regarding convexity:

Select one:

a. The greater the convexity of a security or portfolio of securities, the more insurance or interest rate protection against rate increases

b. High convexity results in less potential gains after interest rate falls

c. Convexity diminishes the error in duration as an investment criterion

d. Convexity is a feature of all fixed-income securities

e. None of the Above

Answer 1

b. High convexity results in less potential gains after interest rate falls

This statement is false. High convexity amplies the effect of interest rate fall on the bond price. Hence, higher the convexity, higher is the change in bond price due the convexity effect and hence higher potential gain after interest rate falls

a. The greater the convexity of a security or portfolio of securities, the more insurance or interest rate protection against rate increases - This statement is true. As interest rates increase, the convexity effect is positive. Hence, high convexity provides a interest rate protection so that if rate increases, the bond price effect due to convexity increases (The overall bond price may fall, but here we consider only about the convexity effect)

c. Convexity diminishes the error in duration as an investment criterion - This statement is true as convexity makes the required adjustment to the bond price change estimation. The combined effect of duration and convexity more effectively describes the bond price.

d. Convexity is a feature of all fixed-income securities - This statement is true as market interest rates affect all the fixed income securities, which further leads to the convexity effect.