While an understanding of the main drivers of interest rate sensitivity, time to maturity, coupon rates and yields is important.
It's not sufficient in practice because what if you want to compare the interest rate sensitivity of two bonds, but one has a longer time to maturity while also having a higher coupon? The time to maturity suggests it should have a higher sensitivity, but the higher coupon suggests it should have lower sensitivity.
So what's the overall impact? Investors need metrics that allow them to accurately compare the interest rate sensitivity of bonds.
These metrics are generally referred to as sensitivity ratios.
There are three commonly used sensitivity ratios, McCauley duration, Modified duration, and DV01.
These ratios allow us to directly compare the interest rate sensitivity of two or more bonds.
We can look at the macauley duration of two bonds and immediately determine which bond is more sensitive.
That is which bond price will change more for the same absolute change in yields modified duration and dvo one go further than just allowing for comparison between bonds.
They allow us to estimate the actual profit and loss impact of a given change in yields.
We can use these metrics to calculate how much money we would expect to lose if yields were to increase by say, 50 basis points or half a percent.
It may seem that modified duration and DV01 are more useful, but in reality as we'll see, the calculation of all three is closely linked.
That's why you often see all three ratios and sometimes additional measures presented together, allowing investors to choose the one they prefer.
It's important to note that none of these measures are static.
You can't just calculate them once and be done with it.
These sensitivity ratios undergo constant change.
As with convexity, the sensitivity of a bond changes when yields change, which means these sensitivity ratios also change.
Additionally, as time passes, the time to maturity of a bond reduces since time to maturity is one of the primary drivers of sensitivity.
These sensitivity ratios reduce over time, even if the level of yields remains unchanged.
