A Highly Accurate Measure of Bond Price Sensitivity to Interest Rates

Abstract

This paper develops a new method to estimate bond price changes in response to changes in interest rates. This method is always more accurate than traditional estimation with modified duration. The price estimates by this new method are very close to price estimates using traditional duration plus convexity when interest rates decrease. If interest rates rise, bond investors will suffer larger price declines than predicted by traditional duration plus convexity. The new estimate avoids this undesirable price overestimation for rising interest rates, and provides an estimate slightly below the true price. For risk averse investors, overestimation of price declines (with the new method) is always better than underestimation of price declines (with traditional duration plus convexity).

Keywords: duration, interest rate, interest rate risk, price estimation, convexity

JEL Classification: G110, G120