In general, the sensitivity of a fixed-income bond is greater if coupon rate is smaller and
its residual period is longer.
Duration is an index of time during which an investor recovers his funds initially
invested. Duration is calculated by finding the ratio of (i) sum of the product of period
and the corresponding present value of cash flows generated by the security, and (ii)
present value of the security. It is expressed in terms of years. It enables to compare
bonds issued with different conditions.
The securities with longer duration have greater volatility than those of shorter duration.
Thus, the higher duration implies greater risk.
If the duration of the asset is higher than that of liability, the financial firm is holding a
long position and then the risk comes from the increase in rates, as decrease in the value
of assets held will be higher than the advantage accruing from a decrease in sum payable.
On the other hand, if the establishment holds a short position, i.e., the duration of the
asset is smaller than that of liability, the risk emanates from a decrease in rates.
The traditional instrument used on financial market is fixed-coupon bond. This
instrument has undergone several modifications to make it adaptable to the environment
characterized by interest rate volatility. The first modification was to reduce maturity
periods of bonds in order to diminish the degree of uncertainty for investors and
borrowers in respect of the stability of interest rates.
The second modification was to issue bonds whose maturity could be prolonged or
shortened so as to reduce the impact of interest rate variations. When the life of bonds is
extended (coupon rate remaining the same) the investor does not suffer the loss of
revenue in the event of general decrease in market rates of interest. Conversely, a
borrower may re-schedule his debt without suffering from an increase of interest rates.
Similarly, maturity may be shortened to avoid any loss from future fluctuations.
The third modification that appeared on the scene in 1970s, relates to bonds with variable
rates. These bonds have their coupon indexed to a rate of reference. This rate is
normally a variable rate plus a spread varying between 1/8 and 2 per cent. The bonds
with variable rates have constituted an adequate response to variations in interest rates of
large amplitude.
Still another modification aimed at changing rate and maturity simultaneously. This
modality may permit constant revenue for a longer period in case of an anticipated
decrease in rates.
An interest rate futures contract is a commitment to deliver (for the buyer of the contract)
financial securities for a specific amount, on a predetermined future date.