Convexity of a Bond is a measure that shows the relationship between bond price and Bond yield, i.e., the change in the duration of the bond due to a change in the rate of interest, which helps a risk management tool to measure and manage the portfolio’s exposure to interest rate risk and risk of loss of expectation. Convexity is a useful indicator of bond price movements when interest rates are more volatile.
In the above graph, Bond A is more convex than Bond B even though they both have the same duration, and hence Bond A is less affected by interest rate changes.
Convexity is a risk management tool used to define how risky a bond is as more the convexity of the bond; more is its price sensitivity to interest rate movements. A bond with a higher convexity has a larger price change when the interest rate drops than a bond with lower convexity. Hence when two similar bonds are evaluated for investment with similar yield and duration, the one with higher convexity is preferred in stable or falling interest rate scenarios as price change is larger. In a falling interest rate scenario again, a higher convexity would be better as the price loss for an increase in interest rates would be smaller.