Interest Rate Sensitivity

Interest rate sensitivity measures the change in the value of a fixed-income investment due to general movement in interest rates. In most cases the value of a fixed-income investments varies inversely with interest rates; this means that when interest rates rise, the value of fixed-income investments decreases, and vice versa. For instance, a bond paying 5% will decrease in value and sell at a discount if prevalent interest rates are at around 10%, but will increase in value and be sold at a premium if interest rates dip to around 3%. Thus, while the income provided by the bond will not change, the value of the bond can vary significantly; this is especially true for bonds with longer maturity periods.

Interest rate sensitivity gap


In order to manage the opportunity cost and potential volatility of fixed-income investments, it’s necessary to categorize these instruments according to their likely interest rate sensitivity. The interest rate sensitivity gap was developed in the mid 1970s in order to class fixed-income investments according to the duration of their maturities. Short-term investments tend to be more resilient since they cover a shorter time period; this limits the potential volatility in comparison to longer-term bonds and securities. The interest rate sensitivity gap was essentially based only on the duration of the fixed-income securities; and as such, is not as accurate as some of the more modern methods. However, it does provide a rough estimate of which investments are likely to lose or gain value when interest rates rise and fall.

Interest rate sensitivity analysis


There are three basic methods for analyzing and determining the interest rate sensitivity risk factor of particular fixed-income investments: duration, average life, and effective duration.
  • Duration is the simplest and least accurate of the three methods; like the interest rate sensitivity gap technique, it is based on the maturity duration of the specific security.
     
  • Average life analysis is applied mainly to mortgage backed securities and is based on the length of time needed to recoup the average weighted value of the principal amounts lent.
     
  • Effective duration is used for calculating the interest rate sensitivity of bonds with embedded options; it takes into consideration the effect of higher interest rates on the probability that the company will call those options. Effective duration takes into consideration the likely changes in cash flow produced by changes in interest rates and, as a result, is one of the most useful ways of estimating interest rate sensitivity.
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