I’m working on a duration question and I got stuck. IF interest rate rise, or if the yield curve steepens, then we would want to reduce our duration or interest rate risk. But what if the interest rate falls? Is that considered an interest rate risk as well? Also, would we want to reduce our duration, or increase it? Thanks so much.
Bear in mind that you want to make the changes to duration _ before _ the interest rates change, not afterward.
If you anticipate interest rates increasing (or the yield curve steepening), you want to shorten your duration.
If you anticipate interest rates decreasing (or the yield curve flattening), you want to lengthen your duration.
Got it. Thank you sir. That was very easy to understand. I appreciate it.
This applies to whose perspective? Investor or borrower? this question might sound stupid.
This is from the investor’s perspective, as they’re long duration (i.e., they own the bonds whose prices change with interest rates).
The borrower is less likely to care about the duration of the bonds; only if they could repurchase their own bonds on the open market would they care, and that would require a source of cash that they’re unlikely to have.
It didn’t sound stupid to me.
Duration is the most commonly discussed type of interest rate risk. It’s well-explained in the above posts: just think of it as the price change due to interest rate risk.
Thereare are also other forms of interest rate risk, including convexity and reinvestment risk. Reinvestment risk occurs when bonds mature. Cash would be reinvested at the short-term interest rate. If rate are low, this poses reinvestment risk because funds would be reinvested at a rate that might be lower than what is needed.