What is Effective Convexity ?
Effective Convexity metric helps investors understand how the bond's duration (interest rate sensitivity) changes as interest rates change. It provides a more accurate reflection of the bond’s price volatility compared to traditional convexity measures by taking into account the potential changes in cash flows due to these options. Effective Convexity helps in understanding the interest rate risk of bonds with embedded options, which can have non-linear price movements in response to yield changes. It aids in more accurate pricing and valuation of bonds, especially those with call or put options, by considering how cash flows change with interest rates. In summary, effective convexity is a crucial metric in fixed income investing, providing a comprehensive measure of interest rate risk for bonds with embedded options by accounting for the potential changes in cash flows due to these options.
How to Calculate Effective Convexity?
Effective Convexity calculator uses Effective Convexity = (Price of Bond When Yield is Decreased+Price of Bond When Yield is Increased-(2*Initial Price of Bond))/((Change in Curve)^2*Initial Price of Bond) to calculate the Effective Convexity, Effective Convexity measures the curvature of the relationship between a bond's price and interest rates, considering changes in cash flows due to embedded options. Effective Convexity is denoted by EC symbol.
How to calculate Effective Convexity using this online calculator? To use this online calculator for Effective Convexity, enter Price of Bond When Yield is Decreased (PV_{-}), Price of Bond When Yield is Increased (PV_{+}), Initial Price of Bond (P_{o}) & Change in Curve (ΔC) and hit the calculate button. Here is how the Effective Convexity calculation can be explained with given input values -> 1.452222 = (19405+470-(2*135))/((10)^2*135).