Beyond Duration: Dissecting Yield Curve Risk

Wesley Phoa, Ph.D.

Yield curve risk measures now go well beyond traditional modified duration. For example, for option-embedded bonds, one must use effective duration instead of modified duration. But how well does effective duration itself capture yield curve risk?

We use principal component analysis to identify the fundamental kinds of yield curve shifts that can occur. Parallel shifts dominate, implying that effective duration is the most important yield curve risk measure.

Yield curve slope shifts are second in importance; non-parallel duration monitors exposure to this source of risk. We analyse this concept, and also assess the importance of other kinds of overall yield curve shifts.

A correlation analysis shows that parallel and non-parallel durations cannot fully capture fluctuations in individual yield spreads. This motivates the use of key rate durations.

The appendix shows how parallel and slope risk arise in a macroeconomic framework.