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Convexity

The Duration approximation of change in price due to changes in the yield works only for small changes. For larger changes there will be a significant error term between the actual price change and that estimated using duration. Convexity improves on this approximation by taking into account the curvature of the price/ yield relationship as well as the direction of the change in yield. By doing so it explains the change in price that is not explained by Duration. A positive convexity measure indicates a greater price increase when interest rates fall by a given percentage relative to the price decline if interest rates were to rise by that same percentage. A negative convexity measure indicates that the price decline will be greater than the price gain for the same percentage change in yield.

 

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