InvestorQ : What is interest rate risk and how to measure interest rate risk of a bond?
Niraja Mehta made post

What is interest rate risk and how to measure interest rate risk of a bond?

Mary Joseph answered.
3 years ago

One of the big risks that the bond investments entail is the interest rate risk. We know about the inverse relationship between bond yields and bond prices. When the bond yields go up the prices come down. That means your capital value comes down and as an investor you are required to make provisions for the asset value depletion. That is called the mark to market (MTM) risk and is the key to managing interest rate risk and trading in bonds.

The management of bond portfolios or fixed income portfolios introduces several unique challenges; among the most important is the ability to determine the risk associated with fixed income instruments. Three of the most important measures of interest rate risk are as under:

§ Macaulay duration

§ Modified duration

§ Convexity

These measures are widely used to determine how sensitive a bond’s price is to changes in market yields or in other words: what is the risk associated with this bond portfolio when market rates change? These measures also called interest rate risk measures quantify the bond portfolio risk. These interest rate risk measures have one major drawback: they are based on the assumption that all promised cash flows will actually materialize. This assumption is especially problematic when bonds contain embedded options (as in the case of bonds with call and put options), which can be used to alter the pattern of cash flows from a bond. In order to properly account for embedded options, more advanced risk measures have been developed; these are known as:

§ Effective duration

§ Effective convexity

The above interest rate risk measures only help you quantify understand the level of risk in a bond portfolio. They do not help you mitigate or manage the bond portfolio risk! Different types of strategies can be used to manage the returns and risk of a bond portfolio. Two of the more widely-used bond portfolio risk management strategies are:

§ Indexing

§ Immunization

Understand duration of the bond is the most important step to understand the impact of bond prices of bonds due to shifts in market yields. This is the basis on which most traders participate and trade in bonds.