Question

Convexity is a desirable feature of bonds because as interest rates decline, the price of a low convexity bond

a. decreases at a decreasing rate.

b. decreases at an increasing rate.

c. increases at a decreasing rate.

d. increases at an increasing rate.

e. decreases at a decreasing rate.

Answer 1

The convexity measures the responsiveness of a bond price to the changes in interest rates.

The degree of convexity shows how much a bond’s yield changes in response to a change in price. Convexity measures the sensitivity of the bond’s duration to change is yield. The higher the convexity, the greater is the change of the bond price to the changes in interest rates.

Bond prices have a inverse relationship to changes in interest rates. In Low convexity bonds , as interest rates decline, bond prices increase at a decreasing rate.\

So, the correct option is option C.

Higher convexity is preferred in a stable or falling interest rate scenarios as price change is larger. In a falling interest rate scenario again a higher convexity would be better as the price loss for an increase in interest rates would be smaller.