Bond Convexity
Duration works very well when interest rates move by small amounts. However, it does not work so well when measuring the impact of large interest rate moves. The reason is that once an interest rate has changed, the underlying value of the bond also changes, and this causes a change of duration. As the value of a bond changes, so does the sensitivity of its price to changes in interest rates.
When a bond becomes less valuable, the impact of changes in interest rates on its price becomes smaller. When a bond becomes more valuable, the impact of changes in interest rates on its price becomes larger. Bond convexity is a measure of how the duration of a bond changes when interest rates change. If an interest rate move is small or the duration of a bond is low, a bond’s convexity will not matter very much. However, for bigger interest rate moves and higher durations, bond convexity becomes a useful tool for understanding interest rate volatility.
Convexity is useful for comparing bonds that have the same duration. If one bond exhibits greater convexity than another bond, changes in interest rates will affect each of the two bonds differently. A bond with greater convexity is less negatively affected by interest rates. For example, if Bond A and Bond B have equal durations, but Bond A h