Impact of Convexity:

Impact of Convexity: Convexity is a measure of the curvature of the relationship between bond prices and changes in interest rates. While duration provides a linear approximation of the price-yield relationship, convexity helps refine this approximation by accounting for the non-linearities.

The impact of convexity on bond prices is as follows:

1. Positive Convexity: Bonds with positive convexity have prices that are more sensitive to decreases in interest rates than to increases. This means that if interest rates decline, the bond’s price will increase by more than what duration alone predicts. Positive convexity provides some cushion against interest rate declines.
2. Negative Convexity: Bonds with negative convexity have prices that are less sensitive to decreases in interest rates and more sensitive to increases. This means that if interest rates rise, the bond’s price will decline by more than what duration alone predicts. Negative convexity exposes investors to more significant downside risk.