Question

“Convexity is something which investors are looking to pay for.” Explain the term Convexity
in fixed-income securities and discuss its implications on investment decisions.

please try to concentrate more on the implications on investment decisions

Answer 1

Convexity, along with bond duration if used for determining the bond prices to the changes in yield.

Generally, as bond yield increases, bond prices fall and vice-versa. This relationship is non-linear in nature. The duration estimates the bond price for linear changes, however, it has to be complemented with convexity to take into consideration the non-linear nature of the bond price changes.

Due to convexity, for a unit decrease in yield, the bond price increases more due to convexity than it would without it. Hence, more the convexity, more is the positive change in bond price when the yield decreases. Also, if yields increases, more the convexity, lesser is the decrease in bond price than it would had been, if the bond had lesser convexity.

Hence, a positive convexity is beneficial for the investor and thus he/she pays for it and the same reasoning is used in investment decisions as well. If an analyst predicts that bond yield would decrease in future, he/she will prefer purchasing a bond with higher convexity to enjoy higher bond prices if his/her predictions comes out to be true. For truly estimating bond prices to change in market yields, duration along with convexity is taken into consideration. Accordinly, convexity plays an important role in investment decisions as the bond prices are dependent on it.