CHAPTER 7
INTRODUCTION TO THE MEASUREMENT OF INTEREST RATE RISK

I. INTRODUCTION

In Chapter 2, we discussed the interest rate risk associated with investing in bonds. We know that the value of a bond moves in the opposite direction to a change in interest rates. If interest rates increase, the price of a bond will decrease. For a short bond position, a loss is generated if interest rates fall. However, a manager wants to know more than simply when a position generates a loss. To control interest rate risk, a manager must be able to quantify that result.
What is the key to measuring the interest rate risk? It is the accuracy in estimating the value of the position after an adverse interest rate change. A valuation model determines the value of a position after an adverse interest rate move. Consequently, if a reliable valuation model is not used, there is no way to properly measure interest rate risk exposure.
There are two approaches to measuring interest rate risk—the full valuation approach and the duration/convexity approach.

II. THE FULL VALUATION APPROACH

The most obvious way to measure the interest rate risk exposure of a bond position or a portfolio is to re-value it when interest rates change. The analysis is performed for different scenarios with respect to interest rate changes. For example, a manager may want to measure the interest rate exposure to a 50 basis point, 100 basis point, and 200 basis point instantaneous change in interest rates. This approach requires ...

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