Question

For fixed coupon bonds, having high convexity is a desirable feature. Which of the following statements is true?

A) When interest rates fall, the price of the bond increases less than a bond with low convexity
B) The duration approximation works well for bonds with high convexity
C) The reason why high convexity is a preferrable feature of a bond is the fact that when interest rates fall/rise the bond price increases/decreases more than when a bond exhibits low convexity
D) The reason why low convexity is a preferrable feature of a bond is the fact that when interest rates rise/fall the bond price increases/decreases more than when a bond exhibits low convexity
E) None of the above results

Answer 1

The correct statement for high convexity in fixed coupon bonds is that when interest rates change, the bond's price is more reactive compared to bonds with low convexity, resulting in more significant price increases when rates fall and smaller price decreases when rates rise.

Step-by-step explanation:

When discussing the characteristics of fixed coupon bonds, the concept of convexity becomes relevant. Convexity measures the curvature of the price-yield relationship of a bond. A bond with high convexity will exhibit a greater change in price for a given change in interest rates than a bond with low convexity. Therefore, when interest rates fall, a high convexity bond's price will increase more, and when rates rise, its price will decrease less compared to a bond with low convexity.

Thus, the correct statement regarding high convexity in fixed coupon bonds is C) "The reason why high convexity is a preferable feature of a bond is the fact that when interest rates fall/rise the bond price increases/decreases more than when a bond exhibits low convexity." High convexity is indeed a desirable feature because it implies that a bond is less sensitive to interest rate changes, providing a form of cushioning against market volatility.