For an investor short a bond, which of the following is true:

For an investor short a bond, which of the following is true:

I. Higher convexity is preferable to lower convexity

II. An increase in yields is preferable to a decrease in yield

III. Negative convexity is preferable to positive convexity
A . I and II
B . II and III
C . I, II and III
D . I and III

View Answer

Answer: B

Explanation:

The effect of higher convexity is that when yields rise, the price decrease is lower than the increase in yields, and when yields fall, the increase in price is greater than the fall in yield. In either case, it benefits the holder of the fixed income instrument that carries such positive convexity. The converse is true for someone short a bond – such an investor would prefer lower convexity to higher convexity. Therefore statement I is not true for an investor who is short a bond.

An increase in yields makes bond prices decrease, something that would benefit the short.

Therefore statement II is true for an investor short a bond.

Negative convexity has exactly the opposite effect as the one described for positive convexity for statement I above. An investor short a bond would prefer negative convexity (which by the way is exhibited by very few fixed income instruments such as mortgages) to positive convexity, therefore statement III is true for such an investor. Choice ‘b’ is the correct answer.