YIELD CURVE RISK
As discussed previously, duration and convexity are measures of what is called level risk if the yield curve shifts in a parallel fashion. That is, if all Treasury rates shifted up or down by the same number of basis points, these measures do a good job of approximating the exposure of a security or portfolio to a change in the level of rates. However, yield curves cannot be expected to change in a parallel fashion. Consequently, two MBS portfolios with the same duration can perform quite differently when the yield curve shifts in a nonparallel fashion.
Illustration of Price Effects: Convexity versus Spread Widening
Several approaches have been suggested for measuring the exposure to a shift in the yield curve. A popular approach for measuring yield curve risk is to change the yield for a particular maturity of the yield curve and determine the sensitivity of a CMO or portfolio to this change, holding all other yields constant. The sensitivity of the change in value to a particular change in the yield is called rate duration. There is a rate duration associated with every point on the yield curve. Consequently, every bond has a profile of rate durations representing each maturity on the yield curve.
The most commonly used approach, first proposed by Thomas Ho,28
focuses on a series of key maturities on the spot rate curve. The durations for ...