medium · Principles of Finance valuation

Which of the following describes the 'negative convexity' behavior often observed in callable bonds as market yields fall significantly below the bond's coupon rate?

1. Negative convexity is purely a theoretical construct and has essentially no real effect on the actual trading price of callable debt.
2. The bond's effective duration increases rapidly as yields decline, making its price considerably more sensitive to any further declines in yield.
3. The bond's price actually falls even as market yields decline, because the embedded call premium is subtracted from its underlying market value.
4. The price appreciation is limited because the likelihood of the issuer exercising the call option increases, truncating the bond's upside.

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