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It can be seen from the above equation that bond prices are inversely related to change in market yield or YTM (i.e. when yields go up, bond prices fall and when yields fall, bond prices increase). Interest rate risk is nothing but the risk of decline in bond prices on account of increase in interest rates or yields.
Modified Duration
Interest rate risk or the interest rate sensitivity (change in bond price for a unit change in yield) varies across bonds. The key variables which determine the interest rate risk of a bond are residual maturity, coupon rate and yield. In general: Bond with longer residual maturity will be more sensitive to interest rate change compared to bond with shorter residual maturity Bond with higher coupon rate will be less sensitive to interest rate change compared to bond with lower coupon rate
Bond having higher yield-to-maturity will be less sensitive to interest rate change compared to bond with lower yield-to-maturity A single measure which captures all these variables and help calculate the magnitude of change in price of a bond for one unit change in interest rate is called Modified Duration.
It may not be necessary to remember these formulas as there are several tools including MS-Excel which can help calculate modified duration of a bond.
Most of the asset management companies in India disclose / publish the modified duration of their fixed income / bond funds in the monthly fact sheet.
Using modified duration to calculate interest rate sensitivity / expected price change of a bond or a bond portfolio for a given change in interest rate
Using the modified duration of a bond or a bond portfolio, expected price change can be calculated using the following equation. Change in bond price = - Modified Duration * ? yield
Where ? yield is the expected change in yield in %. The negative sign in this equation indicates inverse relationship between change in yield and change in bond price.
For example, if the modified duration of a portfolio is 5 and yield is expected to fall by 100 basis points, expected change in price of the portfolio (on account of change in yield) can be calculated as Change in bond price = - 5 * -1% = 5%. The table below illustrates the example of how bond prices get impacted by change in yield and portfolio modified duration. % change in price of bond or bond portfolio
Change in yield 1 -300 bps -200 bps -100 bps -50 bps -25 bps +25 bps +50 bps +100 bps +200 bps +300 bps +3.0% +2.0% +1.0% +0.5% +0.25% -0.25% -0.5% -1.0% -2.0% -3.0% 2 +6.0% +4.0% +2.0% +1.0% +0.5% -0.5% -1.0% -2.0% -4.0% -6.0% Portfolio Modified Duration 3 +9.0% +6.0% +3.0% +1.5% +0.75% -0.75% -1.5% -3.0% -6.0% -9.0% 5 +15.0% +10.0% +5.0% +2.5% +1.25% -1.25% -2.5% -5.0% -10.0% -15.0% 6 +18.0% +12.0% +6.0% +3.0% +1.5% -1.5% -3.0% -6.0% -12.0% -18.0%
+21
+14
+7
+3
+1.
-1.7
-3.
-7.
-14
-21
In Conclusion
Modified duration is a useful tool which helps to compare interest rate risks of bond portfolios or securities of different maturities. Moreover, it also helps in determining approximate change in price of a bond or NAV of a bond portfolio based on forecasted changes in interest rates. However, it is important to remember that that are various other factors such as credit upgrades / downgrades, liquidity, spreads, etc which also influence bond prices and modified duration alone may not be sufficient to evaluate a bond or a bond portfolio.
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o o Glossary Debt Concepts Government borrowing Duration Download Documents Perspective Presentation on Debt Basics Outlook for 2012: Fixed income Outlook: International Debt market High Yield: High hopes for 2012 Dividend Distribution Tax - effective tax rate