The Basics of Managing Interest Rate Risk and the Concept of Duration


By Emily Moré Hollis

Screen Shot 2013-11-13 at 10.10.59 AMThere is nothing wrong with managing a high amount of interest rate risk. In fact, there is nothing wrong with leveraging your capital, actively managing an investment portfolio or issuing 30-year loans to members. Hedges built into leverage strategies can manage interest rate risk and, starting next year, it can be managed by outright derivative purchases. Today, a credit union can do all this by regulation, but it takes work and focus to assess how much is enough. You can’t make that assessment without understanding the basic underpinnings of interest rate risk, which is duration.

A common misconception is that any term that references “duration” refers to a period of time. That is simply not correct. Macaulay duration is the only duration that can accurately be quoted by length of time. Effective and modified durations estimate bond price changes, and the correct way to reference them are not by years, but by percent. They measure the ratio (percent) of the proportional change in bond value (price) to the parallel shift of the spot yield curve. Investment professionals use duration to quickly assess price volatility. (To calculate the “real” price volatility, the concept of convexity would have to be discussed[1].)

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