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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Key Rate Duration

What it is:

Key rate duration is not the same as effective duration. Effective duration is an estimate of a security's sensitivity to a parallel shift in interest rates, meaning that it assumes that interest rates change by the same degree for, say, one-year bonds, five-year bonds, 10-year bonds, and 30-year bonds. That's not often the case in the real world, which is why key rate duration is useful -- it measures a security's price sensitivity to shifts at "key" points along the yield curve. Key duration rates are especially useful for securities with embedded options such as call options or prepayment options.

How it works (Example):

There are 11 maturities along the Treasury spot rate curve, and a key rate duration is calculated for each. The sum of the key rate durations along a portfolio yield curve is equal to the effective duration of the portfolio.

Why it Matters:

Key rate duration is a measure of how a security's value changes when its yield changes by 1% for a certain maturity.

The formula for key rate duration is:

Key Rate Duration = (P- - P+)/(2 * 0.01 * P0)

Where P- = the security price after a 1% decrease in yield
P+ = the security price after a 1% increase in yield
P0 = the original security price

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