Interest Rate Sensitivity

What Is Interest Rate Sensitivity?

Interest rate sensitivity is a measure of how much the price of a fixed-income asset will vacillate because of changes in the interest rate environment. Securities that are more sensitive have greater price vacillations than those with less sensitivity.

This type of sensitivity must be considered while choosing a bond or other fixed-income instrument the investor might sell in the secondary market. Interest rate sensitivity influences buying as well as selling.

How Interest Rate Sensitivity Works

Fixed-income securities and interest rates are conversely corresponded. Hence, as interest rates rise, prices of fixed-income securities will generally fall. When applied to compute fixed income securities, interest rate sensitivity is known as the asset's duration. This is one method for determining what interest rates mean for a fixed-income security portfolio. 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 provides investors with a thought of the sensitivity to potential interest rate changes. Duration is a decent measure of interest rate sensitivity on the grounds that the calculation incorporates different bond qualities, like coupon payments and maturity.

Generally, the more drawn out the maturity of the asset, the more sensitive the asset to changes in interest rates. Changes in interest rates are observed closely by bond and fixed-income traders, as the subsequent price vacillations influence the overall yield of the securities. Investors who comprehend the concept of duration can vaccinate their fixed-income portfolios to changes in short-term interest rates.

Types of Interest Rate Sensitivity

There are four widely utilized duration measurements to determine a fixed-income security's interest-rate sensitivity — the Macaulay duration, modified duration, effective duration, and key rate duration. To work out the Macaulay duration certain metrics must be known, including the opportunity to maturity, remaining cash flows, required yield, cash flow payment, par value, and bond price.

The modified duration is a modified calculation of the Macaulay duration that incorporates yield to maturity (YTM). It determines how much the duration would change for every percentage point change in the yield.

The effective duration is utilized to ascertain the duration of bonds with embedded options. It determines the inexact price decline for a bond in the event that interest rates rise promptly 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.

Illustration of Interest Rate Sensitivity

One widely utilized measure to determine the interest rate sensitivity is the effective duration. For instance, expect a bond mutual fund holds 100 bonds with an average duration of nine years and an average effective duration of 11 years. On the off chance that interest rates rise promptly by 1.0%, the bond fund is in this way expected to lose 11% of its value in view of its effective duration.

Moreover, a trader can take a gander at a particular corporate bond with a maturity of six months and a duration of 2.5. Assuming interest rates fall 0.5%, the trader can anticipate that that the bond's price should rise by 1.25%.

Features

• The more extended the maturity of the asset, the more sensitive the asset to changes in interest rates.
• More interest rate sensitivity means an asset's price vacillates more with a change in interest rates.
• Interest rate sensitivity is how much a fixed-income asset price moves with changes in interest rates.
• Interest rates and fixed-income asset prices are contrarily related.