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Interpretation of Convexity

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asked Nov 16, 2016 in BUS 2016H - Financial Mathematics by Palie (280 points)
Please help me understand why a higher convexity is a better investment option from the point of interest rate risk. 

1 Answer

+2 votes
answered Nov 16, 2016 by Sure (640 points)
selected Nov 16, 2016 by Palie
 
Best answer

If Convexity is high and

(a)interest rates go up, then all investments lose value BUT investments with high convexity lose value by LESS % than those with low convexity. For example, a 1% interest rate rise may result in a 2% drop in value for an investment with a high convexity while an investment with a low convexity will lose 25% in value. So as investors an increase in interest rates "benefits" those with a high convexity due to low % decreases in value of assets.

(b)interest rate drop , then all investments gain value BUT investments with high convexity gain value by MORE % than those with low convexity. For example, a 1% interest rate drop may result in a 25% increase in value for an investment with high convexity while an investment with low convexity will gain 2% in value. So as investors a decrease in interest rates "benefits" those with high convexity due to high % increases in value of their assets.

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