LOS 69 Interest Rate Risk Measurement

a. distinguish between the full valuation approach (the scenario analysis approach)
and the duration/convexity approach for measuring interest rate risk, and explain
the advantage of using the full valuation approach;


The primary focus of interest rate risk is measuring the impact after an adverse rate change. Two approaches are used to measuring interest rate risk: the full valuation approach and the duration/convexity approach.

The full valuation approach also known as scenario analysis. It examines the value of bonds under a variety of interest rate scenario changes. For example, a portfolio manager might examine the change in a bond with assumed interest rate increases of 50, 100,150 and 200 basis point increases and decreases. This approach is useful when there is a good valuation model and can be used for parallel and nonparallel shifts in the yield curve.

Highly leveraged investors (such as hedge fund investors) often use extreme scenario tests, known as stress testing, to examine the impact of wide interest rate changes. This is fine so long as the manager has a good valuation model to estimate what the price of the bonds will be in each interest rate scenario.

The advantage of the duration/convexity measure is that it is a simpler measure that will show how a portfolio or single bond will change if there is change in a parallel fashion.

Material to be added