Interest Rate Risk Estimation: A New Duration-Based Approach

Abstract

Duration is widely used by fixed income managers to proxy the interest rate risk of their assets and liabilities. However, it is well known that the convexity of the price-yield relationship introduces approximation errors that grow with changes in yield. In this paper we suggest a new approach, discrete duration, which significantly improves upon the accuracy of traditional duration methods and achieves a level of accuracy close to the more complex duration plus convexity. In particular, discrete duration performs particularly well for long dated and low coupon rate bonds, where the estimation error is impressively close to zero.