What is 'Interest Rate Sensitivity'

Interest rate sensitivity is a measure of how much the price of a fixed-income asset will fluctuate as a result of changes in the interest rate environment. Securities that are more sensitive have greater price fluctuations than those with less sensitivity. This type of sensitivity must be taken into account when selecting a bond or other fixed-income instrument the investor may sell in the secondary market.

BREAKING DOWN 'Interest Rate Sensitivity'

Generally, the longer the maturity of the asset, the more sensitive the asset to changes in interest rates. Changes in interest rates are watched closely by bond and fixed-income traders, as the resulting price fluctuations affect the overall yield of the securities. Investors who understand the concept of duration can immunize their fixed-income portfolios to changes in short-term interest rates.

Inverse Correlation between Fixed Income and Rates

Fixed-income securities and interest rates are inversely correlated. Therefore, as interest rates rise, prices of fixed-income securities tend to fall. One way to determine how interest rates affect a fixed-income security's portfolio is to determine the duration. The higher a bond or bond fund's duration, the more sensitive the bond or bond fund to changes in interest rates. The duration of fixed-income securities gives investors an idea of the sensitivity to potential interest rate changes. Duration is a good measure of interest rate sensitivity because the calculation includes multiple bond characteristics, such as coupon payments and maturity.

Types of Duration Measurements

There are four widely used duration measurements to determine a fixed-income security's interest rate sensitivity: the Macaulay duration, modified duration, effective duration and key rate duration. To calculate the Macaulay duration, the time to maturity, number of cash flows, required yield, cash flow payment, par value and bond price must be known. The modified duration is a modified calculation of the Macaulay duration. It determines how much the duration would change for each percentage point change in the yield. The effective duration is used to calculate the duration of bonds with embedded options. It determines the approximate price decline for a bond if interest rates rise instantaneously by 1%. The key rate duration determines a fixed-income security's or fixed-income portfolio's duration at a specific maturity on the yield curve.

One widely used measure to determine the interest rate sensitivity is the effective duration. For example, assume a bond fund holds 100 bonds with an average duration of nine years and an average effective duration of 11 years. Therefore, if interest rates rise instantaneously by 1%, the bond fund is expected to lose 11% based on its effective duration.

RELATED TERMS
  1. Dollar Duration

    Dollar duration measures the dollar change in a bond's value ...
  2. Key Rate Duration

    Holding all other maturities constant, this measures the sensitivity ...
  3. Macaulay Duration

    The weighted average term to maturity of the cash flows from ...
  4. Empirical Duration

    The calculation of a bond's duration based on historical data. ...
  5. Sensitivity

    The magnitude of a financial instrument's reaction to changes ...
  6. Bond

    A debt investment in which an investor loans money to an entity ...
Related Articles
  1. Investing

    What Does Duration Mean?

    Duration measures a fixed-income’s sensitivity to changes in interest rates.
  2. Investing

    Immunization Inoculates Against Interest Rate Risk

    Big-money investors can hedge against bond portfolio losses caused by rate fluctuations.
  3. Investing

    Calculating the Macaulay Duration

    The weighted average term to maturity of the cash flows from a bond.
  4. Investing

    The Basics Of Bond Duration

    Duration tells investors the length of time it will take a bond's cash flows to repay the investor the price he or she paid for the bond. A bond's duration is stated as a number of years and ...
  5. Investing

    Why Investors Should Use Duration to Compare Bonds

    Duration is a helpful metric that determines a bond's sensitivity to interest rates.
  6. Investing

    The Time For Short Duration Bonds Is Now

    While the specter of rising interest rates have been haunting the markets for years now, it seems that fear is finally coming true. Given that scenario, the time for bond investors to get short ...
  7. Investing

    Which Long term Bond Mutual Fund to Avoid in 2016?

    Explore long-term bond mutual funds to avoid in 2016, and learn how rising rates may affect some of the best performing bond funds of the last five years.
  8. Investing

    How Rising Interest Rates and Inflation Affect Bonds

    Understand bonds better with these four basic factors.
RELATED FAQS
  1. Which is a better metric, modified duration or Macaulay duration?

    Learn why the modified duration is a more useful metric than the Macaulay duration, and understand how the measures are different ... Read Answer >>
  2. How does duration impact bond funds?

    Learn how duration for a bond fund measures the risk the bond portfolio has to a rise in interest rates, and see how managers ... Read Answer >>
  3. What is the relationship between modified duration and interest rates?

    Learn about modified duration and Macaulay duration, how to calculate the durations of bonds, and how interest rates and ... Read Answer >>
  4. What is the average profit margin of a company in the chemicals sector?

    Learn more about the Macaulay duration and the modified duration, how to calculate a bond's Macaulay duration and modified ... Read Answer >>
  5. What is the risk return tradeoff for bonds?

    Find out more about the Macaulay duration and modified duration, how to calculate them and the difference between the Macaulay ... Read Answer >>
Hot Definitions
  1. Call Option

    An agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument ...
  2. Pro-Rata

    Used to describe a proportionate allocation. A method of assigning an amount to a fraction, according to its share of the ...
  3. Private Placement

    The sale of securities to a relatively small number of select investors as a way of raising capital.
  4. AAA

    The highest possible rating assigned to the bonds of an issuer by credit rating agencies. An issuer that is rated AAA has ...
  5. Backward Integration

    A form of vertical integration that involves the purchase of suppliers. Companies will pursue backward integration when it ...
  6. Pari-passu

    A Latin phrase meaning "equal footing" that describes situations where two or more assets, securities, creditors or obligations ...
Trading Center