What Is Convexity? How Does Convexity Affect Duration-Based Predicted Price Changes for Price

question 54

Essay

What is convexity?
How does convexity affect duration-based predicted price changes for interest rates changes?
Convexity is a measure of the nonlinearity (curvature)of a change in a bond's price caused by a change in interest rates. The level of convexity increases for greater interest rate changes. Duration is a linear estimate of a bond's price change as the interest rate changes from its current level. Due to convexity,the greater the interest rate change,the greater the error in using duration to estimate the bond's price change. For a multimillion-dollar bond portfolio,the dollar errors can be quite significant. In abnormal markets,bond investors may face more or less risk than the bond's duration would imply.
Calculus

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