What is the purpose of effective convexity?

Effective convexity is an important concept used to assess the interest rate risk of a bond with changing cash flows. It expands on the traditional measure of convexity by considering how changes in interest rates affect the price of a bond that has features like callable options or other embedded options that can alter the cash flows received by an investor.

The primary purpose of effective convexity is to provide a more refined measure of how sensitive a bond's price is to changes in interest rates, particularly when the bond’s cash flows can vary due to these optionality features. This is crucial for investors managing portfolios of bonds that may have different call, put, or conversion features which change how the bonds respond to interest rate movements.

Thus, effective convexity allows investors to better understand and manage the interest rate risk inherent in their fixed-income investments, making it a key concept for fixed-income portfolio management.