CFA Level II ExamFixed IncomeHard
A pension fund manager is analyzing a fixed-income portfolio and wants to understand the impact of changes in the level of interest rates on the portfolio's value. The manager is particularly concerned about large interest rate changes, which can lead to significant errors when only using duration. Which of the following measures should the manager also consider to better estimate price changes for large yield movements?
- AYield to Maturity
- BModified Duration
- CConvexity
- DMacaulay Duration
Show answer & explanationAnswer & explanation
Correct answer: C. Convexity
Duration provides a linear approximation of a bond's price change for a given change in yield. However, for large yield changes, this linear approximation becomes inaccurate. Convexity is a second-order measure that accounts for the curvature of the bond price-yield relationship, providing a more accurate estimate of price changes, especially for large yield movements.
Why the other options are wrong
- A. Yield to Maturity is the total return anticipated on a bond if held until it matures and is not a measure used to refine price change estimates for large yield movements.
- B. Modified Duration estimates price changes for small yield movements but is insufficient for large changes due to its linear nature.
- D. Macaulay Duration is a measure of the weighted average time until a bond's cash flows are received and is not directly used to refine price change estimates for large yield movements beyond modified duration.
Bond Convexity
Convexity measures the curvature of a bond's price-yield relationship. It is a second-order measure that helps improve the accuracy of duration-based price change estimates, especially for large changes in interest rates.
- Positive convexity means the price increases more when yields fall than it decreases when yields rise by the same amount.
- Bonds with higher convexity are generally preferred by investors.
- The convexity adjustment is added to the duration estimate for a more precise price change prediction.
Memory trick: Duration's straight line, convexity's curve makes it fine.