Introduction

Key-rate shift analysis is a critical component of understanding the behavior of interest rates and their impact on fixed income securities. In this chapter, we will delve into the concept of key-rate shift analysis, exploring how changes in key rates can affect the value and risk profile of fixed income portfolios. This analysis helps portfolio managers and risk professionals make informed decisions about managing interest rate risk. Let’s dive in.

Key-Rate Shift Analysis

Key-rate shift analysis involves assessing the impact of shifts in specific key interest rates on the overall performance of a fixed income portfolio. Key rates are predefined interest rates at various points along the yield curve. These rates are typically represented by benchmark government bond yields, such as the yields on government bonds with maturities of 1-year, 2-years, 5-years, and so on.

Key-Rate Shift Analysis Components

• Selecting Key Rates: The first step in key-rate shift analysis is selecting the key interest rates to be analyzed. These rates are chosen based on their relevance to the portfolio’s risk profile. For example, a portfolio manager might focus on the 1-year and 5-year key rates if those maturities align with the portfolio’s investments.

• Scenario Generation: Once key rates are selected, various interest rate scenarios are generated. These scenarios involve shifts in the chosen key rates while keeping other rates constant. For example, if we are analyzing the impact of a parallel shift in the 1-year rate, a scenario might involve increasing the 1-year rate by 1%.

• Portfolio Valuation: In each scenario, the portfolio’s value is recalculated. This step involves using the new interest rates to revalue the portfolio’s fixed income securities. The valuation may consider factors like duration, convexity, and cash flows.

Example: Let’s consider an example to illustrate key-rate shift analysis. Suppose a portfolio manager is interested in the impact of a 1% increase in the 5-year key rate on their portfolio. They select this key rate and generate a scenario where the 5-year rate increases by 1%, while all other rates remain unchanged.

Impact Assessment

The portfolio manager then assesses the impact of this rate increase on the portfolio’s value. They may find that the portfolio’s value has decreased due to the inverse relationship between interest rates and bond prices. This analysis helps them quantify the interest rate risk associated with the 5-year key rate.