Question

Explain the difference between a parallel and non-parallel shift in interest rates. Then explain whether the duration matching hedging approach works for both a non-parallel and parallel shift interest rates.

Answer 1

A parallel shift in interest rate means the change in interest rate over different maturities are the same where as a non parallel shift in interest rate means change in interest rate over different maturities are different which leads to different shapes of the curve. For example - twist of the curve is caused due to non parallel shift.

Duration matching is a approach based on the duration of the assets and liabilities. The liabilities being matched and the portfolio of assets should be affected similarly by change in interest rates. This approach has a crucial limitation i.e. it protect against only a parallel change in interest rate and not against non parallel change.

The reason behind hedging works with parallel shift and not with non parallel shift is because duration matching requires the duration of the assets to match the duration of liabilities in order to hedge, where as in non parallel shift it becomes difficult to match them . Therefore duration matching does not work with non prallel