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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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