Part Two

Measures of Interest Rate Risk and Hedging

The interest rate risk of a security is measured by how much its price changes as interest rates change. Not surprisingly, measures of interest rate risk are used routinely in fixed income markets. To hedge the interest rate risk of one set of securities with other securities, traders have to compute how the price of each security responds to changes in rates. To take a view on the level or the shape of the term structure of interest rates in the future, investors have to determine how securities perform under various interest rate scenarios. To ensure that a portfolio of assets can continue to support a portfolio of liabilities, asset-liability managers have to compare the interest rate risks of the two portfolios. Lastly, to carry an appropriate amount of risk relative to a mandate or charter, risk managers need to be able to compute the volatility of fixed income portfolios.

Computing the price change of a security given a change in interest rates is straightforward. For example, given an initial and a shifted spot rate curve, the tools of Part One can be used to calculate the price change of securities with fixed cash flows, and the models of Part Three can be used to calculate the price change of interest rate derivatives. Therefore, the challenge of measuring price sensitivity comes not so much from the computation of price changes given changes in interest rates but in defining what is meant by changes in interest rates. ...