Keyrates
KEY RATE RISK: LOOKING BENEATH THE SURFACE OF INTEREST RATE VOLATILITY
Key Rate Risk: Looking Beneath the Surface of Interest Rate Volatility
By Manpreet Hochadel, CFA manpreet.s.hochadel@jpmorgan.com & William Mirrer william.x.mirrer@jpmorgan.com
“If you know the enemy and know yourself, you need not fear the result of a hundred battles. If you know yourself but not the enemy, for every victory gained you will also suffer a defeat. If you know neither the enemy nor yourself, you will succumb in every battle.” — Sun Tzu, The Art of War. 6th century BC
Interest rate volatility can cause significant anguish and distress to fixed income managers and investors. As interest rates fluctuate over time, yields and returns can change dramatically, creating uncertainty. Since the mid-70’s duration and its derivatives have been universally used to evaluate risk on fixed income. In particular, effective duration, or the sensitivity of a bond’s price to changes in interest rates, has commonly been used to judge the amount of interest rate risk that a particular bond or portfolio is exposed to. While effective duration does give good insight to yield curve positioning, it lacks the breakdown necessary to measure and analyze conscious interest rate bets. As effective duration makes the assumption that interest rates are shifting on a parallel basis, one may ask how to look at risk from non-parallel term structure shifts, which are usually the case in fixed income environments. One answer is Key Rate duration. Key rate duration is defined as the measure of interest rate sensitivity of a security or portfolio to specific key rates on the yield curve, holding all maturities constant. Yield curves typically go through stages that involve steepening, leveling, and curvature, creating an environment that requires specific data to analyze risk properly. Steepening would imply short-term interest rates shifting more than long rates, level movements mimic a parallel shift, and
Key Rate Risk: Looking Beneath the Surface of Interest Rate Volatility
By Manpreet Hochadel, CFA manpreet.s.hochadel@jpmorgan.com & William Mirrer william.x.mirrer@jpmorgan.com
“If you know the enemy and know yourself, you need not fear the result of a hundred battles. If you know yourself but not the enemy, for every victory gained you will also suffer a defeat. If you know neither the enemy nor yourself, you will succumb in every battle.” — Sun Tzu, The Art of War. 6th century BC
Interest rate volatility can cause significant anguish and distress to fixed income managers and investors. As interest rates fluctuate over time, yields and returns can change dramatically, creating uncertainty. Since the mid-70’s duration and its derivatives have been universally used to evaluate risk on fixed income. In particular, effective duration, or the sensitivity of a bond’s price to changes in interest rates, has commonly been used to judge the amount of interest rate risk that a particular bond or portfolio is exposed to. While effective duration does give good insight to yield curve positioning, it lacks the breakdown necessary to measure and analyze conscious interest rate bets. As effective duration makes the assumption that interest rates are shifting on a parallel basis, one may ask how to look at risk from non-parallel term structure shifts, which are usually the case in fixed income environments. One answer is Key Rate duration. Key rate duration is defined as the measure of interest rate sensitivity of a security or portfolio to specific key rates on the yield curve, holding all maturities constant. Yield curves typically go through stages that involve steepening, leveling, and curvature, creating an environment that requires specific data to analyze risk properly. Steepening would imply short-term interest rates shifting more than long rates, level movements mimic a parallel shift, and