How is convexity defined in finance?

Convexity in finance is accurately defined as a measure of how the duration of a bond changes as interest rates change. Specifically, it provides insight into the curvature of the price-yield relationship of a bond. When interest rates change, the price of a bond does not change linearly; instead, it exhibits a curve. This curvature indicates that the bond's price is more sensitive to interest rate changes at higher rates than at lower rates.

Therefore, measuring convexity allows investors to understand how the bond's price will react to fluctuations in interest rates, providing a more comprehensive view of potential price changes than duration alone. This becomes particularly useful in assessing the risk and return profile of fixed-income securities in a fluctuating interest rate environment, enabling more informed investment decisions.

Other options may suggest aspects related to bond investments or risk, but they do not capture the essence of convexity as effectively as its relationship to changing interest rate sensitivity.