Question 3 (15 points) Consider the typical bond pricing function PT i (1+y) Convexity - defined as P"(y) - measures the curvature of the bond pricing function Select the correct statement below. Convexity is important because it is a second order measure of interest rate risk Therefore, for an investor who holds a long bond portfolio, high convexity is NOT desirable because it implies that the bond is riskier than a bond with low convexity. Convexity is important because it is a first order measure of interest rate risk. Therefore, for an investor who holds a long bond portfolio, high convexity is desirable because it implies that the bond has low sensitivity to a increase in the yield and high sensitivity to decrease in the yield. Convexity is important because it is a second order measure of interest rate risk. Therefore, for an investor who holds a long bond portfolio, high convexity is desirable because it implies that all else equal - the bond is less risky than a bond with low convexity, i.e. it has low sensitivity to a increase in the yield and high sensitivity to a decrease in the yield. Convexity is important because it is a second order measure of interest rate risk. Therefore, for an investor who holds a long bond portfolio, high convexity is desirable because it implies that - all else equal the bond is less risky than a bond with low convexity, i.e. it has high sensitivity to a increase in the yield and low sensitivity to a decrease in the yield. Next Page