how interest rate sensitivity works
fixed income securities and interest rates are inversely correlated therefore as interest rates rise prices of fixed income securities tend to fall when applied to calculate fixed income securities interest rate sensitivity is known as the asset s duration this is one way to determine how interest rates affect 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 1the 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 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 types of interest rate sensitivitythere 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 certain metrics must be known including the time 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 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 23example of interest rate sensitivityone widely used measure to determine the interest rate sensitivity is the effective duration for example assume a bond mutual fund holds 100 bonds with an average duration of nine years and an average effective duration of 11 years if interest rates rise instantaneously by 1 0 the bond fund is thus expected to lose 11 of its value based on its effective duration likewise a trader can look at a particular corporate bond with a maturity of six months and a duration of 2 5 if interest rates fall 0 5 the trader can expect that the bond s price to rise by 1 25 