Effective duration measures price sensitivity to small parallel shifts in the yield curve.
Key rate duration is the sensitivity of the value of a security (or a bond portfolio) to changes in a single par rate, holding all other spot rates constant. In other words, key rate duration isolates price sensitivity to a change in the yield at a particular maturity only. Numerically, key rate duration is defined as the approximate percentage change in the value of a bond portfolio in response to a 100 basis point change in the corresponding key rate, holding all other rates constant.
An alternative to decomposing yield curve risk into sensitivity to changes at various maturities (key rate duration) is to decompose the risk into sensitivity to the following three categories of yield curve movements:
- Level (ΔxL) − A parallel increase or decrease of interest rates.
- Steepness (ΔxS) − Long-term interest rates increase while short-term rates decrease.
- Curvature (ΔxC) − Increasing curvature means short- and long-term interest rates increase while intermediate rates do not change.
It has been found that all yield curve movements can be described using a combination of one or more of these movements.