CFA Level II ExamFixed IncomeMedium
A portfolio manager is constructing a portfolio of fixed-income securities and is analyzing the potential impact of interest rate changes on each bond. The manager specifically wants to understand how the bond's price will react to a non-parallel shift in the yield curve, where short-term rates change differently from long-term rates. Which of the following risk measures is most appropriate for assessing this type of interest rate risk?
- AEffective Duration
- BMacaulay Duration
- CKey Rate Duration
- DModified Duration
Show answer & explanationAnswer & explanation
Correct answer: C. Key Rate Duration
Key Rate Duration measures a bond's sensitivity to a 1 basis point change in a specific key rate (e.g., 2-year, 5-year, 10-year spot rates) while holding all other key rates constant. This makes it ideal for analyzing the impact of non-parallel shifts, as it disaggregates interest rate risk across different points on the yield curve.
Why the other options are wrong
- A. Effective Duration measures price sensitivity for bonds with embedded options, accounting for changes in cash flows due to yield changes, but it typically assumes a parallel shift or a specific shift pattern, not isolated key rate changes.
- B. Macaulay Duration is the weighted average time to receipt of a bond's cash flows and is not directly used for non-parallel shifts.
- D. Modified Duration measures the bond's price sensitivity to a parallel shift in the entire yield curve.
Key Rate Duration
Key rate duration measures a bond's or portfolio's sensitivity to a change in a specific maturity segment (key rate) of the yield curve, holding all other rates constant. It helps analyze non-parallel yield curve shifts.
- It decomposes overall duration into contributions from specific maturity points.
- Allows for analysis of twisting and steepening/flattening yield curve shifts.
- The sum of all key rate durations should approximate the bond's effective duration.
Memory trick: Key rates unlock non-parallel shifts, for portfolio lifts.