The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

MEASURING INTEREST RATE RISK

As we explained earlier, a fundamental property of a bond is that its price will change in the opposite direction from the change in the required yield for the bond. This property follows from the fact that the price of a bond is equal to the present value of its expected cash flows. Although all bonds change in price when the required yield changes, they do not change by the same percentage. For example, when the required yield increases by 100 basis points for two bonds, the price of one might fall by 15%, while that of the other might fall by only 1%. To effectively implement bond portfolio strategies, it is necessary to understand why bonds react differently to yield changes. In addition, it is necessary to quantify how a bond’s price might react to yield changes. Ideally, a portfolio manager would like a measure that indicates the relationship between changes in required yields and changes in a bond’s price. That is, a manager would want to know how a bond’s price is expected to change if yields change by, say, 100 basis points.

Here we discuss the characteristics of a bond’s price that affect its price volatility. We present two measures that are used to quantify a bond’s price volatility. One of these measures, duration, is a measure of the approximate percentage change in a bond’s price if yield changes by 100 basis points. Duration, however, provides only an approximation of how the price will change. Duration can be supplemented with ...