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. Investing

    Top 6 Uses For Bonds

    We break down the stodgy stereotype to see what these investments can do for you.
  2. Investing

    Understanding Interest Rates, Inflation And Bonds

    Get to know the relationships that determine a bond's price and its payout.
  3. Financial Advisor

    The Effect of Fed Fund Rate Hikes on Your Bond Portfolio

    Learn how an increase in the federal funds rate may impact a bond portfolio. Read about how investors can use the duration of their portfolio to reduce risk.
  4. Investing

    5 Basic Things To Know About Bonds

    Learn these basic terms to breakdown this seemingly complex investment area.
  5. Financial Advisor

    How to Advise Clients in a Rising Rate Environment

    In the wake of the anticipated rate hike advisors should help clients reassess their portfolios. Here's how.
  6. Investing

    How Rising Interest Rates Impact Bond Portfolios

    A look at the impact that changing interest rates - rising or falling - have on bonds and what investors need to consider.
  7. Investing

    5 Fixed Income Plays After the Fed Rate Increase

    Learn about various ways that you can adjust a fixed income investment portfolio to mitigate the potential negative effect of rising interest rates.
  8. Investing

    How to Manage Risk With Bonds in Your Portfolio

    Bonds are not immune to risk, so be sure to diversify your portfolio with proper asset allocation.
Frequently Asked Questions
  1. Who determines interest rates?

    In countries using a centralized banking model, interest rates are determined by the central bank. In the first step of interest ...
  2. What's the Best Way to Contact Warren Buffett?

    Learn how to contact Warren Buffett and what kinds of contact is most likely to receive a response from him or from his company, ...
  3. What is the Financial Services Sector?

    A diverse group of companies, beyond banks and credit unions, comprises the financial services sector.
  4. Who are Whole Foods' (WFM) main competitors?

    Whole Foods' main competitors are Sprouts Farmers Markets and Trader Joe's. However, the recent acquisition by Amazon my ...
Trading Center