What is Key Rate Duration?
492 reads · Last updated: December 5, 2024
Key rate duration measures how the value of a debt security or a debt instrument portfolio, generally bonds, changes at a specific maturity point along the entirety of the yield curve. When keeping other maturities constant, the key rate duration is used to measure the sensitivity in a debt security's price to a 1% change in yield for a specific maturity.
Definition
Key rate duration refers to how the value of a debt security or a portfolio of debt securities (usually bonds) changes at a specific maturity point on the yield curve. It measures the sensitivity of the price of a debt security to a 1% change in yield at a specific maturity, while other maturities remain unchanged.
Origin
The concept of key rate duration originated from the evolution of duration analysis, initially introduced by Frederick Macaulay in 1938. As financial markets became more complex, investors needed more refined tools to assess the impact of interest rate changes on bond prices, leading to the introduction of key rate duration.
Categories and Features
Key rate duration can be divided into different maturity points, such as 2-year, 5-year, 10-year, etc. Each maturity point's duration reflects the bond's sensitivity to interest rate changes at that specific maturity. Its main feature is providing more precise interest rate risk management, especially when the shape of the yield curve changes. The advantages include more detailed risk assessment, but the disadvantages are complex calculations and the need for extensive data.
Case Studies
Case 1: Suppose an investor holds a portfolio of long-term bonds, primarily focused on the 10-year key rate duration. When the 10-year Treasury yield rises by 1%, the value of this portfolio may significantly decrease. Case 2: An insurance company holds a large number of medium-term bonds, mainly concerned with the 5-year key rate duration. When the 5-year rate decreases by 1%, the insurance company may see an increase in the value of its bond portfolio, affecting its balance sheet.
Common Issues
Investors often confuse key rate duration with regular duration. Key rate duration focuses on interest rate changes at specific maturities, while regular duration measures sensitivity to overall interest rate changes. Additionally, calculating key rate duration requires precise data and complex models, which can lead to errors.
