Question

1.

a) What is negative convexity?

b) Why do callable bonds sometimes have negative convexity?

Answer 1

1. a) Negative convexity: when the yield of a bond increases as price increases, it is said to have negative convexity. the shape of the yield curve with negative convexity is concave.

b) Callable bonds have negative convexity as these bonds can be called by the issuer before the date of maturity , as interest rate falls. As callable bonds are prepaid, these bonds exhibit negative convexity.

The shape of the yield curve is concave, depicting negative convexity.