CFA Level II ExamFixed IncomeMedium
An analyst is comparing two option-free bonds, Bond A and Bond B. Bond A has a modified duration of 5.5 years and a convexity of 45. Bond B has a modified duration of 6.0 years and a convexity of 30. If interest rates are expected to decrease significantly, which bond is likely to experience a larger price increase, and why?
- ABond A, due to its higher convexity.
- BBond B, due to its higher modified duration, despite its lower convexity.
- CBond B, due to its higher modified duration.
- DBond A, due to its lower modified duration and higher convexity.
Show answer & explanationAnswer & explanation
Correct answer: A. Bond A, due to its higher convexity.
When interest rates decrease significantly, both duration and convexity contribute positively to bond price changes. While Bond B has a higher duration, Bond A's significantly higher convexity will likely lead to a larger price increase, as convexity becomes more impactful with larger interest rate changes and amplifies price gains when rates fall.
Why the other options are wrong
- B. The higher duration of Bond B would be beneficial, but its lower convexity would temper the price increase compared to Bond A's higher convexity during a significant rate drop.
- C. While duration is important, the impact of significantly higher convexity on price gains during large rate drops is crucial.
- D. Lower modified duration would typically lead to a smaller price increase, but higher convexity is the dominant factor here.
Convexity and Price Sensitivity
Convexity measures the curvature of a bond's price-yield relationship, indicating how duration changes with interest rates.
- Positive convexity is desirable, especially for large interest rate changes.
- When rates fall, higher convexity leads to greater price appreciation.
- When rates rise, higher convexity leads to smaller price depreciation.
Memory trick: Duration Drives Direction, Convexity Curbs Curves.