What does “interest rate sensitivity” mean?
Interest rate sensitivity is when interest rates change; the price of a fixed-income asset will change by a certain amount. This is called interest rate sensitivity. The prices of securities that are more sensitive change more than those of less sensitive securities.
When a trader picks a bond or other fixed-income security to sell on the secondary market, they must consider this sensitivity. Being sensitive to changes in interest rates affects both buying and selling.
How Sensitivity to Interest Rates Works
Interest rates and fixed-income assets are not related to each other. Because of this, the prices of fixed-income assets tend to go down when interest rates increase. Interest rate sensitivity is the asset’s duration when used to figure out fixed-income assets. This is one way to determine how interest rates affect a collection of fixed-income securities. Short-term bonds and bond funds are more responsive to changes in interest rates than long-term bonds and funds.
When buyers look at fixed-income securities, the duration tells them how sensitive the securities are to changes in interest rates. Duration is an excellent way to determine how sensitive a bond is to changes in interest rates because it considers several bond traits, such as coupon payments and maturity.
Most of the time, an asset is more sensitive to changes in interest rates the longer it matures. Bond and fixed-income buyers pay close attention to changes in interest rates because the resulting price changes affect the overall yield of the securities. If investors understand the idea of duration, they can protect their fixed-income investments from changes in short-term interest rates.
Different kinds of interest rate sensitivity
The Macaulay duration, the modified duration, the effective duration, and the critical rate duration are the four most common duration measures used to determine how sensitive a fixed-income security is to changes in interest rates. You need to know a few things to determine the Macaulay duration. These are the time until maturity, the leftover cash flows, the required yield, the cash flow payment, the par value, and the bond price.
The modified duration is a different way to figure out the Macaulay duration that takes yield to maturity (YTM) into account. It works out how much the time would change for every 1% change in the yield.
The effective duration is used to figure out how long bonds with attached options will last. It figures out how much the price of a bond will drop if interest rates go up by 1% right away. The critical rate duration tells us how long a fixed-income asset or portfolio will last at a certain maturity on the yield curve.
An Example of Being Sensitive to Interest Rates
The effective period is a common way to determine how sensitive an interest rate is. Let’s say a bond mutual fund owns 100 bonds with an average term of nine years and an average applicable term of eleven years. Based on how long the bonds are projected to last, the bond fund will lose 11% of its value if interest rates go up by 1% right away.
Similarly, a trader can look at a company bond that lasts 2.5 months and has a maturity date of six months. The seller can expect the bond price to increase by 1.25 percent if interest rates drop by 0.5 percent.
Conclusion
- Interest rate sensitivity is the amount that the price of a fixed-income asset changes when interest rates do.
- There is a negative relationship between interest rates and the prices of fixed-income assets.
- The price of an item changes more when interest rates change if it is more interest rate-sensitive.
- When interest rates change, an object is likelier to lose value if the maturity date is later extended.
