Key Rate Duration
What Is Key Rate Duration?
Key rate duration measures how the value of a debt security or a debt instrument portfolio, generally bonds, changes at a specific maturity point along the entirety of the yield curve. While keeping different maturities consistent, the key rate duration is utilized to measure the sensitivity in a debt security's price to a 1% change in yield for a specific maturity.
The Formula for Key Rate Duration
Where:
- 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
Ascertaining Key Rate Duration
For instance, 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% diminishing in yield would be priced at $1,040. in view of the formula over, the key rate duration for this bond would be:
What Does Key Rate Duration Tell You?
Key rate duration is an important concept in assessing the expected changes in value for a bond or portfolio of bonds since it does so when the yield curve shifts in a way that isn't entirely parallel, which happens frequently.
Effective duration — another important bond metric — is a keen duration measure that likewise works out expected changes in price for a bond or portfolio of bonds given a 1% change in yield, yet it is just legitimate for parallel shifts in the yield curve. To this end the key rate duration is such a significant measurement.
Key rate duration and effective duration are connected. There are 11 maturities along the Treasury spot rate curve, and a key rate duration might be calculated for each. The sum of all the 11 key rate durations along the portfolio's yield curve equivalent the effective duration of the portfolio.
Illustration of How to Use the Key Rate Duration
It tends to be challenging to decipher an individual key rate duration since it is impossible that a single point on the treasury yield curve will have an upwards or downwards shift at a single point while all others stay steady. It's helpful for seeing key rate durations across the curve and checking out at the relative values of key rate durations between two securities.
For instance, 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 a key rate durations of 1.2 and 0.3 for these maturity points, individually. One might say that bond X is half basically as sensitive as bond Y on the short-term finish of the curve, while bond Y is one-third as sensitive to interest rate changes on the intermediate part of the curve.
Features
- The key rate duration works out the change in a bond's price comparable to a 100-premise point (1%) change in the yield for a given maturity.
- At the point when a yield curve has a parallel shift, you can utilize effective duration, however key rate duration must be utilized when the yield curve moves in a non-parallel way, to estimate portfolio value changes.
- Duration measures let you know the price risk implied in holding fixed income securities given a change in interest rates.
