What Is Key Rate Duration?
Key rate duration measures how the value of a security or portfolio changes at a specific maturity point along the entirety of the yield curve. When keeping other maturities constant, the key rate duration can be used to measure the sensitivity in a security's price to a 1% change in yield for a specific maturity.
The Formula for Key Rate Duration
- P- = a security's price after a 1% decrease in its yield
- P+ = a security's price after a 1% increase in its yield
- P0 = the security's original price
Calculating Key Rate Duration
As an example, assume that a bond is originally priced at $1,000, and with a 1% increase in yield would be priced at $970, and with a 1% decrease in yield would be priced at $1,040. based on the formula above, the key rate duration for this bond would be:
Key rate duration=($1,040−$970)/(2×1%×$1,000)=$70/$20=3.5
What Does Key Rate Duration Tell You?
Key rate duration is an important concept in estimating the expected changes in value for a bond or portfolio of bonds because it does so when the yield curve shifts in a manner that is not perfectly parallel, which occurs often.
Effective duration—another important bond metric—is an insightful duration measure that also calculates expected changes in price for a bond or portfolio of bonds given a 1% change in yield, but it is only valid for parallel shifts in the yield curve. This is why key rate duration is such a valuable metric.
Key rate duration and effective duration are related. There are 11 maturities along the Treasury spot rate curve, and a key rate duration may be calculated for each. The sum of all the 11 key rate durations along the portfolio's yield curve equal the effective duration of the portfolio.
- Key rate duration calculates the change in a bond's price in relation to a 100-basis-point (1%) change in the yield for a given maturity.
- When a yield curve has a parallel shift, you can use effective duration, but key rate duration must be used when the yield curve moves in a non-parallel manner, to estimate portfolio value changes.
Example of How to Use the Key Rate Duration
It can be difficult to interpret an individual key rate duration because it is very unlikely that a single point on the Treasury yield curve will have an upwards or downwards shift at a single point while all others remain constant. It's useful for looking at key rate durations across the curve and looking at the relative values of key rate durations between two securities.
For example, assume bond X has a one-year key rate duration of 0.5 and a five-year key rate duration of 0.9. Bond Y has key rate durations of 1.2 and 0.3 for these maturity points. It could be said that bond X is half as sensitive as bond Y on the short-term end of the curve, while bond Y is one-third as sensitive to interest rate changes on the intermediate part of the curve.