Interest Rate Volatility and Bond Prices

Managing interest rate risk requires measuring it first. Duration analysis has become an important tool, allowing portfolio managers to measure the sensitivity of their portfolios to changes in the level of interest rates. But duration analysis has a number of serious drawbacks. Standard duration analysis, for instance, allows for only parallel shifts in the term structure. Thus portfolio managers may remain exposed to substantial risk arising from nonparallel shifts. Furthermore, because duration and convexity analyses focus on the risk of changes in the level of interest rates, they ignore other types of relevant risks, including changes in the frequency of large movements in interest rates.