Convexity

Categories: Derivatives, Stocks

Judge: Your word is convexity.

Spelling Bee Participant: Convexity. Language of origin?

Judge: Middle French, and before that, Latin.

Spelling Bee Participant: Alternate pronunciations?

Judge: None.

Spelling Bee Participant: Does it come from the Latin root “convexus,” meaning "vaulted, arched?"

Judge: Yes. Why on earth would someone know that?

Spelling Bee Participant: Can you use it in a sentence?

Judge: "Hey, Paul, did you know that bonds with less convexity are more impacted by interest rates than bonds with more convexity?"

Spelling Bee Participant: Can I just have the d*** definition please?

Judge: When you grow up and take a job as a bond trader, you little snob, you’ll learn that convexity is a measurement that shows how changes in interest rates affect the price of a bond.

Okay, okay...enough. Bond convexity is an advanced concept which maps the duration of a bond, i.e. how long until it comes due...against the interest rate or total yield that it is offering.

Think about one bond coming due in a month, and another coming due in 15 years. Let's say the interest rates of the bonds change by 100 basis points, or 1 percent, suddenly. Well, annualized, that due-in-a-month bond only changes by 0.1%, whereas the streams of throw from the due-in-15-years bond will change massively based on that 1 percent change.

Bond "convexity" refers to the convex shape on the graph. If you can figure out how this works and maps mathily, then, well...you don't need us.

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