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312 Learning Module 12 Yield-Based Bond Convexity and Portfolio Properties

PRACTICE PROBLEMS
1. A 5.5% semiannual-pay fixed-coupon bond is issued at par on 1 May 2025 and
matures on 1 May 2029. For a 5 bps increase and decrease in yield-to-maturity,
PV+ and PV– are 98.245077 and 101.792534, respectively. The approximate con-
vexity is closest to:
A. 3.548.

B. 15.045.

C. 101.793.

2. A bond pays a semiannual fixed coupon of 4.75%. It trades at par on its coupon
date of 16 December 2025 and matures on 16 December 2033. The bond’s annu-
alized convexity statistic is closest to:
A. 51.670.

B. 53.231.

C. 206.681.

3. For changes in yield-to-maturity, the convexity adjustment is most needed to

account for the:
A. first-order effect on bond prices.

B. bond price risk due to small changes in yield-to-maturity.

C. non-linear relationship of bond prices and yield to maturity.

The following information relates to questions

4-9
A bond portfolio consists of the following three option-free, fixed-rate bonds:

Bond Market Value (£) Annual Modified Duration Annual Convexity

X 5,000,000 3.6239 16.2513

Y 5,000,000 9.0036 91.0278
Z 10,000,000 12.7512 179.8591

4. If the yield-to-maturity of Bond X increases by 50 bps, the expected percentage

price change of Bond X is closest to:
A. –1.792%.

B. –1.812%.

C. –1.832%.

5. Given a 75 bps change in the yields-to-maturity for Bonds Y and Z, the convexity
adjustment for Bond Z would be greater than the convexity adjustment of Bond
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Practice Problems 313

Y:
A. if the YTM change is positive.

B. if the YTM change is negative.

C. regardless of the direction of the change in YTM.

6. For a 100 bps increase in yield-to-maturity and using money duration and money
convexity, the estimated change in Bond Y’s full price is closest to:
A. –GBP472,937.

B. –GBP450,180.

C. –GBP427,423.

7. For a 100 bps increase in yield-to-maturity and using the weighted average dura-
tion and convexity, the expected percentage price change for the bond portfolio is
closest to:
A. –7.981%.

B. –8.949%.

C. –9.533%.

8. The bond portfolio’s benchmark is a fixed-income index with a duration of 9.5325

and convexity of 103.0677. Based on the weighted-average portfolio duration and
convexity, the portfolio should outperform its benchmark in which of the follow-
ing scenarios?
A. Only when interest rates are rising

B. Only when interest rates are falling

C. Both when interest rates are rising and falling

9. The method of using weighted-average portfolio duration and convexity mea-

sures to assess price risk of a bond portfolio is best characterized as:
A. being theoretically correct.

B. being commonly used by portfolio managers.

C. accommodating non-parallel shifts in the yield curve.

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314 Learning Module 12 Yield-Based Bond Convexity and Portfolio Properties

SOLUTIONS
1. B is correct.
101.792534 + 98.245077 − (​ 2 × 100)​
​ApproxCon = __________________________
​
       )2
​ = 15.044498.​
( ​ 0.0005 ​ ​× 100

2. A is correct.

Eight-Year, 4.70% Semiannual Bond

Fixed Coupon (%) 4.70

Periods p.a. 2
Price (per 100 Par Value) 100
Yield-to-Maturity (%) 4.70

Col. 6 = Col. 2 × Col. 7 = Col. 2 × (Col. 2 + 1)

Col. 1 Col. 2 Col. 3 Col. 4 Col. 5 Col. 5 × Col. 5 × (1 + YTM/2)–2

Time to Time to Receipt ×

Period Cash Flow Present Value Weight Convexity of Cash Flows
Receipt Weight

1 1.0 2.35 2.296043 0.02296 0.02296 0.04384

2 2.0 2.35 2.243325 0.02243 0.04487 0.12849
3 3.0 2.35 2.191817 0.02192 0.06575 0.25108
4 4.0 2.35 2.141492 0.02141 0.08566 0.40886
5 5.0 2.35 2.092323 0.02092 0.10462 0.59920
6 6.0 2.35 2.044282 0.02044 0.12266 0.81962
7 7.0 2.35 1.997344 0.01997 0.13981 1.06774
8 8.0 2.35 1.951484 0.01951 0.15612 1.34129
9 9.0 2.35 1.906677 0.01907 0.17160 1.63811
10 10.0 2.35 1.862899 0.01863 0.18629 1.95617
11 11.0 2.35 1.820126 0.01820 0.20021 2.29351
12 12.0 2.35 1.778336 0.01778 0.21340 2.64827
13 13.0 2.35 1.737504 0.01738 0.22588 3.01871
14 14.0 2.35 1.697610 0.01698 0.23767 3.40315
15 15.0 2.35 1.658632 0.01659 0.24879 3.80002
16 16.0 102.35 70.580104 0.70580 11.29282 183.26330
100.0000 1.00000 13.51910 206.68136
Annualized Convexity 51.67034

3. C is correct. The convexity adjustment is a complementary risk measure to

duration. It accounts for the second-order (non-linear) effect of yield changes on
price. It is most useful for large yield changes, because duration provides a good
approximation for small yield changes.

4. A is correct. The expected price change is calculated as follows:

%ΔPVFull ≈ (–3.6239 × 0.005) + [½ × 16.2513 × (0.005)2]
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Solutions 315

= –1.79164% ≈ –1.792%.

5. C is correct. Since the convexity adjustment uses the square of the change
in yield, it is always positive regardless of the direction of the change in
yield-to-maturity. As a result, the convexity adjustment for Bond Z will always
be greater than the convexity adjustment for Bond Y, given the same change in
yields-to-maturity.

6. C is correct.
MoneyDur ≈ 9.0036 × 5,000,000 = 45,018,000

MoneyCon ≈ 91.0278 × 5,000,000 = 455,139,000

ΔPVFull ≈ –(45,018,000 × 0.01) + [½ × 455,139,000 × (0.01)2] = –GBP427,423.

7. B is correct. The portfolio weights for Bonds X, Y, and Z are 0.25, 0.25, and 0.50,
respectively. The weighted average duration and convexity measures are calculat-
ed as follows:
Weighted-average duration = (0.25 × 3.6239) + (0.25 × 9.0036) + (0.50 × 12.7512)
= 9.5325.

Weighted-average convexity = (0.25 × 16.2513) + (0.25 × 91.0278) + (0.50 ×

179.8591)
= 116.7493.

%ΔPVFull ≈ (–9.5325 × 0.01) + [½ × 116.7493 × (0.01)2] = –8.9487% ≈ –8.949%.

8. C is correct. The portfolio has a weighted-average duration of 9.5325, which is

identical to the benchmark’s duration. However, the portfolio has higher convexi-
ty (116.7493) compared to the benchmark (103.0677). All else equal, the portfolio
should outperform the lower-duration benchmark portfolio in both rising and
falling interest rate environments.

9. B is correct. The weighted-average portfolio duration and convexity method

is easy to calculate and apply in practice and is commonly used by portfolio
managers to assess bond portfolio price risk. It does, however, implicitly assume
parallel shifts in the yield curve. Using the weighted average of time to receipt of
the aggregate cash flows is the theoretically correct method to calculate portfolio
duration and convexity, but it is difficult to use in practice.