What Is Interest Rate Sensitivity?
Let me explain interest rate sensitivity to you—it's a measure of how much the price of a fixed-income asset will fluctuate due to changes in the interest rate environment. If a security is more sensitive, you'll see greater price fluctuations compared to those with less sensitivity.
You have to take this type of sensitivity into account when you're selecting a bond or other fixed-income instrument that you might sell in the secondary market. It affects both buying and selling decisions.
Key Takeaways
- Interest rate sensitivity is how much a fixed-income asset price moves with changes in interest rates.
- Interest rates and fixed-income asset prices are inversely correlated.
- More interest rate sensitivity means an asset's price fluctuates more with a change in interest rates.
- The longer the maturity of the asset, the more sensitive the asset to changes in interest rates.
How Interest Rate Sensitivity Works
Fixed-income securities and interest rates are inversely correlated, so as interest rates rise, prices of fixed-income securities tend to fall. When you're calculating this for fixed-income securities, interest rate sensitivity is known as the asset's duration. This is one way you can determine how interest rates affect your fixed-income security portfolio. The higher a bond or bond fund's duration, the more sensitive it is to changes in interest rates.
The duration of fixed-income securities gives you an idea of the sensitivity to potential interest rate changes. Duration is a good measure because the calculation includes multiple bond characteristics, such as coupon payments and maturity.
Generally, the longer the maturity of the asset, the more sensitive it is to changes in interest rates. Bond and fixed-income traders watch changes in interest rates closely, as the resulting price fluctuations affect the overall yield of the securities. If you understand the concept of duration, you can immunize your fixed-income portfolios against changes in short-term interest rates.
Types of Interest Rate Sensitivity
There are four widely used duration measurements to determine a fixed-income security's interest-rate sensitivity: the Macaulay duration, modified duration, effective duration, and key rate duration. To calculate the Macaulay duration, you need certain metrics, including the time to maturity, remaining cash flows, required yield, cash flow payment, par value, and bond price.
The modified duration is a modified calculation of the Macaulay duration that incorporates yield to maturity (YTM). It determines how much the duration would change for each percentage point change in the yield.
The effective duration is used to calculate the duration of bonds with embedded options. It determines the approximate price decline for a bond if interest rates rise instantaneously by 1%. The key rate duration determines a fixed-income security's or fixed-income portfolio's duration at a specific maturity on the yield curve.
Example of Interest Rate Sensitivity
One widely used measure to determine interest rate sensitivity is the effective duration. For example, assume a bond mutual fund holds 100 bonds with an average duration of nine years and an average effective duration of 11 years. If interest rates rise instantaneously by 1.0%, you can expect the bond fund to lose 11% of its value based on its effective duration.
Likewise, consider a trader looking at a particular corporate bond with a maturity of six months and a duration of 2.5. If interest rates fall 0.5%, the trader can expect that the bond's price to rise by 1.25%.
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