From the course: Fixed Income Fundamentals

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The effect of convexity on bond price

The effect of convexity on bond price

From the course: Fixed Income Fundamentals

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The effect of convexity on bond price

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- [Instructor] Once we've figured out what convexity is for a bond, we can use this convexity adjustment to further hone the accuracy of our calculation of the price impact on a bond given changes in yield. To recap our learning, we use duration to calculate the price given for a given change in yield. That's good for small variances in yield. However, as duration is an approximation based on a tangent to a point, the calculation won't take into consideration how the curvature of the bond's price-yield relationship impacts the price change. That's where this adjustment for convexity comes in. In order to figure out the actual change in price as a percentage, we use the formula change in price is equal to duration effect plus the convexity adjustment. Expanding on that more, it becomes negative modified duration, multiplied by change in yield, plus 1/2 of convexity times the change in yield squared. The reason we use the negative of modified duration is because of the negative…

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