5.3.3. Bond Convexity
Duration works well when interest rates move by small amounts. However, it does not work as 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 exhibits greater convexity, changes in interest rates will affect each bond differently. A bond with greater convexity is less negatively affected b