Fixed Income Investments - Measuring Interest Rate Risk

The Full Valuation Approach
The full valuation approach to measuring the interest rate risk is to re-value the bond or portfolio for a given interest-rate change scenario. This rate change can be parallel or non-parallel. It is also referred to as a scenario analysis because it involves the way in which your exposure will change as a result of certain interest rate scenarios. For example, an investor may evaluate the portfolio based on an increase in rates of 50, 100 and 200 basis points. Each bond is valued and then the total value of the portfolio is computed under the various scenarios.

The Duration/Convexity Approach
In contrast, the duration/convexity approach just looks at one time parallel move in interest rates using the properties of price volatility.

Because the full valuation approach uses various outcomes to measure the risk of the bond or portfolio, as compared to a one time move for the duration/convexity approach, it bears that the full valuation approach is better suited to measuring interest-rate risk even though it can be very time consuming.

Example: Compute the Interest-Rate Risk Exposure
Let's take an option-free bond with an 8% coupon, ten-year bond with a price of 125. Yield to maturity is 7%

Answer:
Scenario 1 is an increase of 50bps that drives the price down to 120 (this is just an estimate). To see the percentage change you take the new price after the yield change and subtract it from the initial price after the change divided by the initial price.

120 - 125 / 125 = -.04 = a 4 % decrease in the price of the bond due to a 50 bps change

Scenario 2 is an increase of 100 bps that drives the price down to 114.

114 - 125 / 125 = - .088 = an 8.8% decrease in price due to a 100 bps change.

You can use this for any type of scenario concerning a change in yields.

Price Volatility
Related Articles
  1. Professionals

    Chinese Slowdown Affects Iron Ore Market

    The Chinese economy's ongoing slowdown is having a major impact on iron ore demand.
  2. Personal Finance

    Invest in Costco? First Understand Its Balance Sheet

    A strong balance sheet sets a company apart and boosts investor confidence. How healthy is Costco based on an analysis of its balance sheets from the last two years?
  3. Investing Basics

    Brokers and RIAs: One and the Same?

    Brokers and registered investment advisors have some key differences. Here's what you need to know.
  4. Professionals

    DCF Vs. Comparables: Which One To Use

    DCF and Comparables models are widely used in equity valuation. We explain the pros and cons of each method.
  5. Professionals

    How To Make Money Using Tobin's Q Ratio

    Although it seems simple, Tobin's Q Ratio is more complex than it appears. We explore some of its main strengths and weaknesses.
  6. Taxes

    3 Secrets You Didn't Know About Estate Planning

    Every advisor and saver needs to know these three estate planning secrets.
  7. Professionals

    Cash Flow Is King: How to Keep it Running

    Why is cash flow so important, and what steps can a business take to improve it?
  8. Entrepreneurship

    10 Ways to Nurse Cash Flow in Healthcare

    Running a business in healthcare? You might want to rethink cash flow management practices.
  9. Professionals

    How to Help Clients with Cash Flow Issues

    Sometimes your spending gets out of hand or income has a hiccup. Here's how financial advisors can help clients who have cash flow issues.
  10. Professionals

    How to Improve Your Cash Flow in Manufacturing

    Here are 10 ways to to improve a manufacturer's cash flow.
RELATED TERMS
  1. Personal Financial Advisor

    Professionals who help individuals manage their finances by providing ...
  2. CFA Institute

    Formerly known as the Association for Investment Management and ...
  3. Chartered Financial Analyst - CFA

    A professional designation given by the CFA Institute (formerly ...
  4. Security Analyst

    A financial professional who studies various industries and companies, ...
RELATED FAQS
  1. What are the differences between a Chartered Financial Analyst (CFA) and a Certified ...

    The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >>
  2. How do I become a Chartered Financial Analyst (CFA)?

    According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >>
  3. What types of positions might a Chartered Financial Analyst (CFA) hold?

    The types of positions that a Chartered Financial Analyst (CFA) is likely to hold include any position that deals with large ... Read Full Answer >>
  4. Who benefits the most from prepaid expenses?

    Prepaid expenses benefit both businesses and individuals. Prepaid expenses are the types of expenses that are bought or paid ... Read Full Answer >>
  5. If I am looking to get an Investment Banking job. What education do employers prefer? ...

    If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Full Answer >>
  6. Can I still pass the CFA Level I if I do poorly in the ethics section?

    You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Full Answer >>
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!