Interest Rate Risk

Why interest rate risk matters

Rates are discount factors and financing prices across the economy. When yields rise, fixed-rate bond prices generally fall, long-duration assets often reprice, and borrowers face higher refinancing costs. Falling rates create reinvestment risk and can increase the value of liabilities. Institutions need to manage assets and obligations together because a bond loss may be offset by a favorable change in the present value of future payments.

How it is applied

Duration estimates the first-order percentage price response to a parallel yield change, while convexity refines the estimate for larger moves. Key-rate duration measures sensitivity at separate maturities, exposing curve-shape risk. Managers also model basis risk, optionality, deposit behavior, funding, and currency. Scenario tests apply parallel shifts, steepening, flattening, and historical shocks. Hedging can use government bonds, futures, swaps, or options, subject to basis and liquidity risk.

Formula

Portfolio example

A bond portfolio has modified duration of 6. If yields rise by 0.50 percentage points, the first-order estimate is a 3% price decline. Convexity and spread changes may alter the actual result. If the portfolio funds a liability with duration of 10, the institution may still have a duration mismatch even though the asset loss seems manageable. Hedging only the total duration may leave exposure to curve changes.

How to interpret it

Positive duration usually means value falls as yields rise. Longer duration indicates greater sensitivity, not necessarily greater credit risk. Floating-rate instruments can have low price duration but expose income and borrower credit quality to higher rates. An apparently neutral aggregate duration can hide offsetting large positions at different maturities. Interpretation should include curve, optionality, inflation, currency, funding, and the duration of relevant liabilities.

Limitations and common misconceptions

Duration is a local approximation and works less well for large or nonparallel moves. Callable bonds, mortgages, and options have sensitivities that change with rates. Credit spreads may move at the same time and can dominate government-yield effects. Model assumptions about prepayments, deposits, and reinvestment may fail. A hedge can introduce basis, collateral, and counterparty risk. Scenario analysis and cash-flow review are necessary alongside summary duration.