Question

Reflect on a graph for capturing two different bonds whose inverse relationship between price and interest rate is indicated by curves tangential at a single point but one more convex than the other. Why do bond investors prefer the bond with the greater convexity for investing as compared to the one with the lesser convexity?

Answer 1

We see a negative relation between bond prices and interest rates. A decrease in interest rates results an increase in bond prices. There is a higher increase in bond prices of more convex bond as compared to less convex bond.

If the interest rate increases, more convex bond depreciates lesser in value as compared to less convex bond.

Hence, there is a higher positive impact and lower negative impact for more convex bonds as compared to less convex bonds. Hence investors prefer to invest in more convex bonds.