How to Estimate Price Changes from Interest Rate Increases

How can you approximate the percentage price change from an increase in interest rates?

• A. -spread duration x change in bps
• B. Duration x change in yield
• C. -2 x change in rates
• D. Delta x rate change

Answer: (A)

The correct answer highlights the relationship between interest rates and bond prices through the concept of spread duration. Spread duration measures the sensitivity of a bond's price to changes in credit spreads, and it can serve as a proxy for estimating price changes in response to shifts in interest rates, especially in a fixed-income context. When interest rates rise, bond prices usually fall, and the percentage change in price can be approximated by multiplying the negative spread duration by the change in basis points (bps). This is because a larger spread duration implies greater sensitivity to interest rate movements. As such, the formula captures the negative impact of increasing rates on the bond's price. In investment analysis, understanding this relationship is vital for managing interest rate risks in portfolios, as it illustrates how changes in market conditions can directly affect asset valuations. This approach is particularly helpful when evaluating the potential effects of interest rate hikes on fixed-income instruments. Other approaches mentioned, while relevant to various contexts, do not specifically address the interaction between changes in interest rates and the resulting impact on fixed-income securities, making them less suitable for this particular question.

How to Estimate Price Changes from Interest Rate Increases

Let’s kick things off with a pivotal concept for any CFA Level 3 candidate: understanding how interest rates affect bond prices. You’re probably aware that when rates climb, bond prices tend to take a nosedive. But how can we quantify that change? Well, here’s where the savvy realm of spread duration comes into play.

What’s Spread Duration, Anyway?

You may ask yourself,