Brief of measurement of interest rate risk, Financial Management

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  • A manager must be able to quantify as to what will result from an adverse change in interest rates to control interest rate risk.

  • Different types of valuation models are in use to determine the value of apposition after an adverse rate move. Two widely used models are: Full valuation model and duration/convexity approach.

  • Full valuation approaches revalue the bond position for a given interest rate change scenario.

  • The characteristics of a bond that affect its price volatility are maturity, coupon rate, and presence of any embedded options.

  • Duration is the first approximation of a bond's price or a portfolio's value to rate changes.

  • Duration is good to estimate the percentage price change for a small change in interest rates but the estimation becomes inferior when you have to estimate larger change in interest rate.

  • The duration of the portfolio is equal to the market-value weighted duration of each bond in the portfolio.

  • A convexity measure can be used to improve the estimate of the percentage price change obtained using duration, particularly for a large change in yield.

 


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