Hit by Convexity

Photograph by Michael Gottschalk/AP Photo

Convexity is a measure of the curvature or 2nd derivative of how the price of a bond varies with the interest rate, i.e. how the duration of a bond changes as the interest rate changes. Specifically, one assumes that the interest rate is constant across the life of the bond and that changes in interest rates occur evenly. Using these assumptions, duration can be formulated as the first derivative of the price function of the bond with respect to the interest rate in question. Then the convexity would be the second derivative of the price function with respect to the interest rate.

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