Chartered Financial Analyst (CFA) Practice Exam Level 2

What does Key Rate Duration measure?

1. The price sensitivity of a bond to changes in credit risk.

2. The price sensitivity of a bond to changes in rate at specific maturities.

3. The overall risk of a bond portfolio.

4. The average time to receive cash flows from a bond.

The correct answer is: The price sensitivity of a bond to changes in rate at specific maturities.

Key Rate Duration measures the price sensitivity of a bond or bond portfolio to changes in interest rates at specific maturities. This concept is crucial for managing interest rate risk because it allows investors to understand how much the price of a bond will change with a shift in rates at different points along the yield curve. For instance, if a specific key rate duration is analyzed for a bond, it indicates how much the bond's price is expected to change for a 1 basis point change in interest rates at that particular maturity. This allows investors to pinpoint which parts of the yield curve they are most exposed to and make more informed decisions regarding hedging or adjusting their portfolio to mitigate risk. Key Rate Duration is particularly useful in situations where the yield curve is not parallel, meaning that different maturities react differently to interest rate changes. As a result, it provides a more nuanced view of interest rate risk than using a single measure like modified duration, which assumes a uniform shift in rates across the entire yield curve. This measure is integral for investors who wish to manage their bond portfolios actively, enabling them to tailor their exposure based on interest rate expectations for specific segments of the curve.