Convexity is essentially the “measure of the sensitivity of the duration of a bond to changes in interest rates”.
It basically tells us how much a change in interest rates will effect the price of a bond that we currently own.
Bonds supply traders with two types of incomes, a series of periodic coupon payments (the amount of which depends on the coupon rate of the bond) and principal, which is paid at the end of the bond’s maturity.
As my professors continously remind us, interest rates and bond prices have an INVERSE relationship. When rates increase, prices decrease. When rates decrease, prices increase.
For example, say you have a 6% bond and interest rates rise from 6% to 7%.
Why would anyone want your 6% bond if they could buy a bond that pays 7%? Now, you have to sell your bond for less money (the price of the bond decreases) because no one will buy it at its current price.
But what if rates decrease from 6% to 5%? Then you can sell your bond for a premium, for higher than what the market is currently paying.
But this movement isn’t always linear. Bonds move more when rates decline as compared to when they increase.
This is CONVEXITY.
For example. when we look at a 3%, 30 year bond, we can see that a 1% (100 basis points) drop in interest rates causes the bonds to increase by 22%. A 1% increase in interest rates causes the bonds to drop 17%. That’s a 5% difference in movement, simply due to direction.
This is depicted visually in the above graph.
BONDS ARE NOT LINEAR. They exemplify convexity. When we place trades, it is good to remember that, especially in an environment where bonds are relatively stagnant. This knowledge will allow us to exploit the smallest deviations from stagnation to our benefit!!
Disclaimer: These views are not investment advice, and should not be interpreted as such. These views are my own, and do not represent my employer. Trading has risk. Big risk. Make sure that you can balance your risk/reward, and trade small, and trade often.