Question

You hold a portfolio of bonds with a total duration of 7.3 and convexity of 65. You expect a parallel increase in yields of 5%. What is the expected percentage change in value?

Answer 1

The expected percentage change in value is calculates as follows:

Expected percentage change in value = {-Modified duration*Change in yields}+{1/2*Convexity*Change in yields}

Duration measures how long will it take to pay the bond price fully. Convexity measures the sensitivity of change in price when there is change in yields, as price yield curve is not linear as assumed by duration formula. Hence the formula as above;

Expected percentage change in value = (-7.3*5%)+{1/2*65*5%)

= -36.5+1.625 = -34.875%

The value is expected to decrease by 34.875% (When bond yield increases, bond price falls)

Assuming the bond duration given in the question as modified duration.