Explain how one-sided and key rate durations help assess the rate sensitivity of bonds that contain embedded options
The idea
One-sided durations measure sensitivity to a fall and to a rise in rates separately: down-duration = (PV₋ − PV₀) ÷ (ΔCurve × PV₀) and up-duration = (PV₀ − PV₊) ÷ (ΔCurve × PV₀). They reveal asymmetry that a single effective duration averages away. For a callable bond near its call price, the down-duration is smaller, because the call caps gains when rates fall. For a putable bond near its put price, the up-duration is smaller, because the put limits losses when rates rise. Key rate durations show which points on the curve matter: a callable bond deep in the money is most sensitive to the rate at its call date.
In the app: 2 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →More in Valuation and Analysis of Bonds with Embedded Options
- Explain bonds and other debt securities that contain embedded options
- Explain how a callable or putable bond's value links to the value of its embedded option and of the equivalent straight bond
- Explain how to apply the arbitrage-free approach when valuing a bond that contains embedded options
- Explain the effect of interest rate volatility on what a callable or putable bond is worth
- Explain the effect of shifts in the yield curve's level and shape on what a callable or putable bond is worth
- Use an interest rate tree to work out what a callable or putable bond is worth
- Explain how option-adjusted spreads are computed and what they are used for
- Explain the effect of interest rate volatility on option-adjusted spreads
- Work out a callable or putable bond's effective duration and explain what it means
- Contrast the effective durations of straight, callable and putable bonds
- Contrast the effective convexities of straight, callable and putable bonds
- Work out what a floating-rate bond with a cap or a floor is worth
- Set out the key characteristics of a convertible bond
- Work out the parts that make up a convertible bond's value and explain what they mean
- Explain how to value a convertible bond within an arbitrage-free framework
- Weigh the risk and return profile of a convertible bond against the profiles of a straight bond and the underlying common shares