What is Convexity?
Convexity relates to the interaction between a bond's price and its yield as it experiences changes in interest rates.
By measuring the change in duration as interest rates fluctuate, convexity, a measure of the curvature of changes in the price of a bond in proportion to changes in interest rates, corrects this inaccuracy.
Consider the case of convexity, which occurs when all spot rates change by the same amount.
Example of Convexity:
The formula is as follows:
B=the bond price
r=the interest rate
For example, consider a 200-basis-point increase in all rates for the bond in our example. The bond's price declines to USD 986,448.71 (a decrease in value of USD 51,473.32). Using duration alone indicates a price change of:
-2.56 * 1,037,922.03 * 0.02 = -53,141.61
But using the duration + convexity result it gives,
-53,141.61 + 1/2 * 8.246 * 1,037,922.03 *0.022 = -51,429.04
which is reasonably accurate.