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Sensitivity of bond prices to interest rates is broken down into two components: (1) Duration, and (2) Convexity. Duration measures the negative impact of interest rates. When rates go up, bond prices go down and vice-versa. This relationship is always negative. Convexity measures the second order effect, and is always positive, whether rates go up or down. Thus, convexity reduces the negative impact of interest rates on bond prices when rates go up and it enhances the impact of interest rates when rates go down. For small changes in interest rates, the effect of convexity is small and is often ignored. Convexity is multipled by the square of the change in interest rates and is added to the duration effect.
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