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Explain in detail what is meant by convexity

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Question - A non-callable 4-year UK government bond pays semi-annual coupons. The face value is £1000, the annual coupon rate is 6% and the yield to maturity is 4% per year.

(a) Show clearly how the current market price and annual modified duration are calculated from the data above. Then discuss how the modified duration may be used to estimate the price change resulting from a 1% change in the annual yield.

(b) Explain in detail what is meant by convexity with regard to the relationship between price and yield, and how this will impact on your price change estimate in part (a). Assume convexity is 15.18.

(c) In addition to convexity, are there any other limitations to using the modified duration to estimate bond price changes? Discuss.

(d) Some bonds are issued with embedded options, which impacts the relationship between price and yield. Explain this phenomenon with regard to 'call' and 'put' options.

Reference no: EM132975881

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