Page 14 - FINAL CFA SLIDES DECEMBER 2018 DAY 15

LOS 54.c: Explain why effective duration is the
most appropriate measure of interest rate risk Session Unit 16:
for bonds with embedded options., p.107 54. Understanding Fixed Income Risk and Return

The fact that bonds with embedded options have uncertain future cash flows means that our present value
calculations for bond value based on YTM cannot be used. We therefore need bond prices/values (movements)

and as these are contingent on exercise or not for bonds with embedded options, and because the future cash
flows of such bonds depend not only on future interest rates but also on the path that interest rates take over
time (did they fall to a new level or rise to that level?), we need a pricing model to take into account these

variables/factors. Effective duration allows us to achieve this more clearly!

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LOS 54.d: Define key rate duration and describe the use of key rate durations in measuring the sensitivity of bonds
to changes in the shape of the benchmark yield curve., p. 108

A key rate duration (also known as a partial duration) is the sensitivity of the value of a bond or
portfolio to changes in the spot rate for a specific maturity, holding other spot rates constant. A bond
or portfolio will have a key rate duration for each maturity range on the spot rate curve.

It is particularly useful for measuring the effect of a nonparallel shift in the yield curve on a bond

portfolio. We can use the key rate duration for each maturity to compute the effect on the portfolio
of the interest rate change at that maturity. The effect on the overall portfolio is the sum of these
individual effects.