Key rate duration is a measure of how a security's value changes when its yield changes by 1% for a certain maturity. The formula for key rate duration is: Key Rate Duration = (P - - P +)/ (2 * 0.01 * P 0)
What is key rate duration and why is it important?
Key rate duration measures the duration of a security or portfolio at a specific maturity point along the entirety of the yield curve. When keeping other maturities constant, the key rate duration can be used to measure the sensitivity in a bond's price to a 1% change in yield for a specific maturity.
What is the key rate duration of a bond?
Key rate duration is the duration at specific maturity point on the yield curve. Keeping all other maturities constant, key rate duration is a measure of the sensitivity of a bond’s price to a 100 basis point change in yield for a given maturity. When the yield curve changes in a non-parallel manner,...
What is the key rate?
In other words, it measures a security’s sensitivity to shifts at “key” points along the yield curve. The key rate formula is similar to the effective duration formula, except that it uses 0.01 in the denominator to reflect a 1% (100 basis points) change in the yield at a specific point on the yield curve:
How do you calculate key rate duration from the yield curve?
When the yield curve changes in a non-parallel manner, key rate durations (and not the portfolio’s effective duration) must be used to estimate the change in portfolio value. Key rate duration is calculated using the following formula: Where: P – = Price with a 1% decrease in yield. P + = Price with a 1% increase in yield. P 0 = Original price.
How do you calculate key rate duration?
The Formula for Key Rate Duration P- = a security's price after a 1% decrease in its yield. P+ = a security's price after a 1% increase in its yield. P0 = the security's original price.
What is key rate duration CFA?
Key rate duration is a measure of a bond or bond portfolio's sensitivity to a 100-basis point – 1% – change in yield at a specific maturity point.
What does negative key rate duration mean?
So, a negative key rate duration means that when that key rate rises the bond's price rises, and when that key rate falls the bond's price falls: a positive relationship between the bond price and the key rate.
What are the three types of duration?
This measure can be used for comparing the sensitivities of bonds with different maturities. There are three different ways to arrive at duration measures, viz. Macaulay Duration....Table of contents#1 – Macaulay Duration.#2 – Modified Duration.#3 – Effective Duration.
What does key rate mean?
The key rate is the specific interest rate that determines bank lending rates and the cost of credit for borrowers. The two key interest rates in the U.S. are the discount rate and the federal funds rate.
What is the duration rate?
Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates. In general, the higher the duration, the more a bond's price will drop as interest rates rise (and the greater the interest rate risk).
What does duration mean in bonds?
What is bond duration? Bond duration is a way of measuring how much bond prices are likely to change if and when interest rates move. In more technical terms, bond duration is measurement of interest rate risk.
What is key rate exposure?
Key rate exposures help to describe the risk distribution along the term structure given a bond portfolio. They help describe how to execute the perfect hedge using highly liquid benchmark bonds.
What does effective duration mean?
What Is Effective Duration? Effective duration is a duration calculation for bonds that have embedded options. This measure of duration takes into account the fact that expected cash flows will fluctuate as interest rates change and is, therefore, a measure of risk.
What are the different types of duration?
There are two types of duration: Macaulay duration and modified duration.
How do you calculate duration?
What is the Duration Formula? The formula for the duration is a measure of a bond's sensitivity to changes in the interest rate, and it is calculated by dividing the sum product of discounted future cash inflow of the bond and a corresponding number of years by a sum of the discounted future cash inflow.
What is duration example?
Duration is how long something lasts, from beginning to end. A duration might be long, such as the duration of a lecture series, or short, as the duration of a party. The noun duration has come to mean the length of time one thing takes to be completed.
What is the difference between effective duration and modified duration?
Effective duration differs from modified duration because the latter measures the yield duration – the volatility of the interest rates in terms of the bond's yield to maturity – while effective duration measures the curve duration, which calculates the interest rate volatility using the yield curve as a benchmark.
What is key rate exposure?
Key rate exposures help to describe the risk distribution along the term structure given a bond portfolio. They help describe how to execute the perfect hedge using highly liquid benchmark bonds.
What does effective duration mean?
What Is Effective Duration? Effective duration is a duration calculation for bonds that have embedded options. This measure of duration takes into account the fact that expected cash flows will fluctuate as interest rates change and is, therefore, a measure of risk.
How do you interpret Macaulay duration?
Macaulay duration can be viewed as the economic balance point of a group of cash flows. Another way to interpret the statistic is that it is the weighted average number of years that an investor must maintain a position in the bond until the present value of the bond's cash flows equals the amount paid for the bond.
Why is key rate duration important?
The key rate duration is an important metric for determining possible bond value changes resulting from yield changes for the bond’s maturity. Key rate duration is considered an improvement over using the effective duration metric, which can only be applied when there are parallel changes in the yield all across the yield curve.
What is the key rate duration metric used for?
If an investor clearly knows how he or she expects interest rates to move over a given time frame, they can then use the key rate duration metric to figure out which bond maturities are likely to offer the most profitable investment returns (assuming that the investor’s interest rate predictions prove to be correct). Thus, the metric can be used to compare various prospective fixed-income investments.
What is effective duration?
Effective Duration Effective duration is the sensitivity of a bond's price against the benchmark yield curve.
What is bond pricing?
Bond Pricing Bond pricing is the science of calculating a bond's issue price based on the coupon, par value, yield and term to maturity. Bond pricing allows investors. Non-Callable Bond A non-callable bond is a bond that is only paid out at maturity.
Do interest rates increase or decrease for short term bonds?
In real life, such a phenomenon rarely, if ever, occurs. Interest rate increases or decreases for short-term bonds do not typically parallel rate increases or decreases for long-term or medium-term bonds. In fact, interest rates for different maturities of bonds may even be moving in opposite directions, with, for example, long-term interest rates increasing while the interest rate on short-term bonds is declining.
Is key rate duration a superior metric to effective duration?
The key rate duration is considered a superior metric to effective duration. It is because the effective duration metric is only applicable to parallel shifts in interest rates and the yield curve. Yield Curve The Yield Curve is a graphical representation of the interest rates on debt for a range of maturities.
Why is key rate duration important?
The key rate duration presents an improvement to the effective duration because it gives the expected changes in price when the yield curve shifts in a manner that is not perfectly parallel. In other words, it measures a security’s sensitivity to shifts at “key” points along the yield curve. The key rate formula is similar to ...
What is the key rate formula?
The key rate formula is similar to the effective duration formula, except that it uses 0.01 in the denominator to reflect a 1% (100 basis points) change in the yield at a specific point on the yield curve:
What is effective duration?
The effective duration calculates expected changes in price for a bond or portfolio of bonds given a basis point change in yield. This, however, is only valid for parallel shifts in the yield curve. The key rate duration presents an improvement to the effective duration because it gives the expected changes in price when the yield curve shifts in a manner that is not perfectly parallel. In other words, it measures a security’s sensitivity to shifts at “key” points along the yield curve.
Can key rate durations be interpreted in isolation?
Interpreting each key rate duration in isolation can be quite difficult. That’s because, in practice, it’s highly unlikely that a single point on the yield curve will exhibit an upwards or downwards shift while all other points remain constant. For this reason, analysts tend to compare key rate durations across the curve.
What is key rate duration?
The key rate duration of a debt security or a debt instrument portfolio, often bonds, examines how the value of a debt security or portfolio varies at a certain maturity point throughout the whole yield curve.
Key Points Briefly
Using the key rate duration, you can determine how much a bond's price changes when the yield on the bond changes by one percentage point (100 basis points) throughout its entire term.
What is Key Rate Duration Formula?
Here, we will look at key rate duration formula and understand it better with an example.
Key Rate Duration - Example
Let us take the example of the asset, whose original price is 1,575 and there was a fall in in its value to $1,250 due when there was 1 percent rise in its bond maturity. However, there was a price increase to 1,750 when that bond maturity value dropped.
The Importance of the Key Rate's Time Duration
The predicted change in value resulting from a change in the yield on a bond or bond portfolio with a given maturity is represented by the key rate duration. It is presumptively assumed that the yields for all other maturities would remain constant.
When to use key rate duration?
You can use Key Rate Duration when making investment decisions. For example, if the current rate on your bond is higher than its key rate, then there may be an opportunity to sell your bond at a profit because its value will fall as interest rates rise. On the other hand, if the current rate on your bond is lower than its key rate, then there may be an opportunity to buy your bond at a discount because its value will rise as interest rates fall.
Why is key rate duration important?
Key rate duration is an important concept in estimating the expected changes in value for a bond or portfolio of bonds because it does so when the yield curve shifts in a manner that is not perfectly parallel, which occurs often. Effective duration, another important bond metric, is an insightful duration measure that also calculates expected changes in price for a bond or portfolio of bonds given a 1% change in yield, but it is only valid for parallel shifts in the yield curve. This is why key rate duration is such valuable metric.
Why is it so difficult to interpret key rate duration?
It can be difficult to interpret an individual key rate duration because it is very unlikely that a single point on the Treasury yield curve will have a upwards or downwards shift at a single point while all others remain constant. It's useful for looking at key rate durations across the curve and looking at the relative values of key rate durations between two securities.
What is duration bond?
Duration is a measure of the bond’s sensitivity to interest rate changes.
How many variables are used to calculate key rate duration?
The formula for calculating key rate duration uses three separate variables. They are
What is the key rate?
The key rate determines the interest rate of banks on debts when they don't meet up with their required reserves. The Federal Reserve or other banks may lend them for a very short period. Oct 3, 2019
What does negative duration mean?
In other words, negative duration happens when the bond prices go up along with interest rates and vice versa. Negative duration means negative bank equity.
What Is the Key Rate?
The key rate is the specific interest rate that determines bank lending rates and the cost of credit for borrowers. The two key interest rates in the U.S. are the discount rate and the federal funds rate. These are rates that are set, either directly or indirectly, by the Federal Reserve, in order to influence lending and the supply of money and credit in the economy.
Why do we use key rates?
Special Considerations. Key rates are one of the chief tools used by the Federal Reserve system to implement monetary policy. When the Federal Reserve wants to expand the money supply in the economy, it will typically lower discount rates in order to decrease the cost of borrowing.
What happens when the Federal Reserve sets the discount rate?
The Federal Reserve sets the discount rate which, in turn, impacts the Federal funds rate. If the discount rate is increased, banks are reluctant to borrow given that the cost of borrowing has been set higher.
What is the rate that banks can borrow from other banks at?
The rate that banks can borrow from other banks at is called the discount rate . The rate banks borrow from the Federal Reserve at is called the federal funds rate. When a large percentage of account holders decide to withdraw their funds from a bank, the bank may be faced with liquidity issues or insufficient funds.
What are the two types of key rates?
The two types of key rates are the discount rate and the federal funds rate . The key rate will determine the rate at which banks can borrow in order to maintain its reserve level. The Federal Reserve can influence the rate at which banks can borrow money in order to expand or contract the national economy.
What is the Federal Funds Rate?
The Federal funds rate is the rate at which banks can charge each other on loans used to meet their reserve requirements. This rate governs the overnight lending of Federal Reserve funds made available to private-sector banks, credit unions, and other loan institutions.
How does increasing key rates affect the economy?
By increasing the key rates, the cost of borrowing increases, causing consumers to save more and spend less, therefore causing the economy to contract. Lowering key rates will lower the cost of borrowing and cause a decrease in saving and increase in spending—expanding the economy.
What Is Duration?
Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates. A bond's duration is easily confused with its term or time to maturity because certain types of duration measurements are also calculated in years.
What Are Some Different Types of Duration?
A bond's duration can be interpreted in several ways. The Macauley duration is the weighted average time to receive all the bond's cash flows and is expressed in years. A bond's modified duration converts the Macauley duration into an estimate of how much the bond's price will rise or fall with a 1% change in the yield to maturity.
Why is modified duration important?
The modified duration of a bond helps investors understand how much a bond's price will rise or fall if the YTM rises or falls by 1%. This is an important number if an investor is worried that interest rates will be changing in the short term. The modified duration of a bond with semi-annual coupon payments can be found with the following formula:
How does the duration of a zero coupon bond work?
The duration of a zero-coupon bond equals its time to maturity since it pays no coupon.
Why is it called duration?
Duration measures a bond price's sensitivity to changes in interest rates—so why is it called duration? A bond with a longer time to maturity will have a price that is more sensitive to interest rates , and thus a larger duration than a short-term bond.
Why is the duration of a bond confusing?
A bond's duration is easily confused with its term or time to maturity because certain types of duration measurements are also calculated in years. However, a bond's term is a linear measure of the years until repayment of principal is due; it does not change with the interest rate environment.
What is the purpose of duration?
Duration can measure how long it takes, in years, for an investor to be repaid the bond’s price by the bond’s total cash flows. Duration can also measure the sensitivity of a bond's or fixed income portfolio's price to changes in interest rates.
Key Rate Duration vs. Effective Duration
Formula For Calculating The Key Rate Duration
- Where: 1. P–– A bond’s price after a 1% decrease in yield 2. P+– /the bond’s price after a 1% increase in yield 3. P0 – The original price of the bond
Practical Example
- Assume that a given bond is originally priced at $1,000 and that a 1% increase in yield for the bond’s maturity would cause the value of the bond to decline to $980, while a 1% yield decrease would result in the bond’s value increasing to $1,030. Using the formula shown above, the bond’s key rate duration would be calculated as follows: Key Rate Duration = (1030 – 980) / (2 * 0.01 * 1…
Significance of The Key Rate Duration
- The key rate duration reflects the expected change in value resulting from a yield change for a bond or bond portfolio with a specific maturity. It assumes the yields for all other maturities are kept the same. There are more than ten different bond maturities for U.S. Treasuries, and the investor can calculate the key duration for every different ...
What Is Key Rate Duration?
How Does Key Rate Duration Work?
- There are 11 maturities along the Treasury spot rate curve, and a key rate duration is calculated for each. The sum of the key rate durations along a portfolio yield curve is equal to the effective durationof the portfolio.
Why Does Key Rate Duration Matter?
- Key rate duration is a measure of how a security's value changes when its yield changes by 1% for a certain maturity. The formula for key rate duration is: Key Rate Duration = (P- - P+)/(2 * 0.01 * P0) Where P- = the security price after a 1% decrease in yield P+ = the security price after a 1% increase in yield P0= the original security price