A 12.75-year maturity zero-coupon bond selling at a yield to maturity of 8% (effective annual yield) has convexity of 150.3 and modified duration of 11.81 years. A 30-year maturity 6% coupon bond making annual coupon payments also selling at a yield to maturity of 8% has nearly identical duration 11.79 years but considerably higher convexity of 231.2.

1. (a)Suppose the yield to maturity on both bonds increases to 8.5%. What will be the actual percentage capital loss on each bond? What percentage capital loss would be predicted by the duration-with-convexity rule?
2. (b)Repeat part (a), but this time assumes the yield to maturity decreases to 7.5%.
3. (c)Compare the performance of the two bonds in the two scenarios, one involving an increase in rates, the other a decrease. Based on the comparative investment performance, explain the attraction of convexity.