Duration and Immunization of Interest Rate Risk

After the financial tsunami of 2008, the US government is printing a huge amount of money to finance the deficit as well as to stimulate the economy. One of the direct consequences of the currency injection is the downward force upon the already low interest rate. In a professional seminar organized by HKU SPACE College of Business and Finance, Dr. Dominic Li, Consultant and Associate Head, College of Business and Finance, HKU SPACE, highlighted the imminent need for enterprises of various sizes to prepare for any changes in interest rate, most likely a hike, judging from the fact that we are now in a historical low.

Using Duration Measures to Quantify Risk Exposure

Professor Alice Xie from College of Business of University of Michigan-Dearborn was invited to deliver her research findings and insights. She stated that the interest rate is believed to rise eventually, as a measure against inflation pressures. She then explained in detail the concept of duration and how to use duration to immunize interest rate risks. Professor Xie said, “First of all, we have to understand that interest rate risk is a major type of risk associated with investing in bonds. There are three types of duration measures used to quantify a bond’s (or a bond portfolio’s) exposure to interest rate risk – namely the Macaulay Duration, Modified Duration and Effective Duration.” 

One major similarity between Macaulay Duration and Modified Duration is that they assume cash flows do not change when interest rates change, while effective duration takes into account changes in cash flows under the same situation.  In practice, the Macaulay Duration is a popular measure employed by practitioners to immunize interest rate risk. Real-life examples, including a life insurance company in this case, are quoted to further explain the concept.

Various Factors Analysed

Professor Xie also pointed out that even though extensive studies in duration have been carried out, there are quite a lot of questions needed to be researched on. The possible impact of sovereign risk and call risk upon bond duration is one of the topics shared in the seminar.

For people who are interested in future interest rate changes and risks involved, but not really a practitioner in the finance sector, some of the concepts and calculations put forth by Professor Xie may be a bit technical. But before the seminar came to an end, participants attention was drawn to the Professor Xie’s explanations on the implications to Bond Portfolio Managers. She said, “It is not proper to directly use the Macaulay Duration to measure and immunize interest rate risk of a bond subject to different types of risk, as the adjustments could be different for bonds with different characteristics and over different stages in the business cycle.”