RSM430H1 Lecture Notes - Lecture 9: Corporate Bond, Yield Curve, Derivative
Document Summary
Duration tries to estimate convex relationship with straight tangent line. Duration is only good for small changes in yield. Modified duration does not work for large change in yield. Convexity is additional measure to capture curvature or convexity of a bond. Convexity measures the sensitivity of a bond"s duration to changes in yield. First derivative measures how price changes with rates. Second derivative measures how first derivative changes with rates. Convexity is change in slope of price-yield curve for small change in yield. Second derivative of price yield curve provides basis for convexity calculations. This measures percent change in price of bond due to convexity. P1 is price if yields decline by y. P2 is price if yields increase by y. Add modified duration and convexity adjustment to predict total percentage change in bond price due to a change in yield. Modified duration will have a bigger influence on change in price than convexity.
