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Convexity

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Published: 17th February 2010 by William Webster

Convexity is often used to describe how the value of a fixed coupon bond alters with respect to interest rates. This explanation of convexity considers the value of a bond with a principal amount of $10,000,000, a coupon of 5% and a maturity of 10 years. This bond pays the investor $500,000 every year and returns the principal at maturity.

The market value of the bond is the sum of its discounted cash flow values. If different interest rates are used to discount those cash flows the value of the bond will change.

The higher the interest rate the lower the value of the bond becomes. Let's look at this bond's value at interest rates between 0% and 10%.

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