Explain the concept of bond convexity.

Explain the concept of bond convexity.

Bond convexity is a measure of the sensitivity of a bond's price to changes in interest rates. It takes into account the relationship between the bond's price and its yield, and how this relationship changes as interest rates fluctuate. Convexity measures the curvature of the bond's price-yield relationship, indicating whether the bond's price will increase or decrease at a faster or slower rate than predicted by its duration. A positive convexity implies that the bond's price will increase at a faster rate than predicted by duration when interest rates decrease, providing potential capital gains. Conversely, a negative convexity suggests that the bond's price will decrease at a faster rate than predicted by duration when interest rates increase, leading to potential capital losses.