27 Nov
Convexity of Bonds | CA Final SFM
Convexity
It is known that when interest rate expected by the investor (Desired Yield Rate) changes, the value of the bond will also change. The desired yield rate and bond value are inversely related to each other. Therefore, when desired yield rate increases the bond value declines and vice-versa. When this inter-relationship is presented graphically, the outcome will not be a straight line but a curve which will be convex to the origin. Measuring convexity is measuring the rate of change in the slope of this curve.
Convexity = [latex]\dfrac { \sum { n\left( n+1 \right) PV } }{ { V\left( 1+i \right) }^{ 2 } }[/latex]
Where,
n | = | Number of years |
PV | = | Present value of cash flows at nth year. |
V | = | Value of Bond |
i | = | Expected Rate of Return |
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