What is a negative convexity?
Negative convexes is a characteristic of a loan, which is best displayed mainly by an unusual pattern in the yield curve. These characteristics will reverse the normal situation that the longer the debt has to reach, the higher the interest rate. Mortgages supported by securities are one of the most common forms of debts that may have a negative convexity. One example of the usual forms of this relationship comes with savings in the bank, which are actually a loan from the customer to the bank. The bank usually pays a higher interest rate for a savings account where the money must be left in the bank for a specified period of time before paying for a check -up account where the money can be removed quickly. Similarly, a money -lending company usually pays a higher annual interest rate by issuing a bond if it has a longer bond. In both examples, the higher rate is effectively the price for the guarantee that money has longer.
This relationship means that in most pRomes The yield curve graph shows a convex curve, which means that the interest rate is reduced up before leveling. This is because, for example, the difference between a 1 -year -old and a two -year loan is much more significant than between 24 years and a 25 -year loan. In situations with negative convexity, the curve is partially or completely concave. This means that at some points the interest rate slopes downwards to increase time to maturity.
Looking at the negative convexity for bonds, economists and investors, they usually approach this problem from the second perspective. Rather than watching the duration of the loan affects interest rates, they focus on how interest rates affect the duration of the loan. It is generally believed that the concave yield curve is, the less sensitive the price people pay for bonds is changes in interest rates.
One common area where debt can have negative convexes is election bonds. These are bonds where the issuing company that is effectiveSomeone has the right to repay the bond before the agreed due date. If interest rates fall, the company may find that it is better to take a new loan at a lower rate and use the money to repay the bond soon.
Another area with negative convexity is securities supported by a mortgage. This is because the mortgages themselves are often based on variable mortgages. When interest rates drop, homeowners more often pay off the loan faster and pay it in full earlier. This means that the reduction in interest rates has shortened the duration of the loan. Owners of securities supported by a mortgage often focus on protection against this variation of purchase or selling long -term assets, such as government bonds cannot be repaid soon.