Question

What happens when the modified duration of the portfolio is greater than the implied sensitivity? what happens to the net position if there is an upward shift in the yield curve?

Answer 1

Modified duration measures the expected change in a bond's price to a 1% change in interest rates. Also it is found that bond prices have an inverse relationship with interest rates. Thus, rising interest rates indicates the bond prices are likely to fall,while declining interest rates indicates the bond prices are likely to rise. So,when the modified duration is greater than the implied sensitivity it results in more sensivity of the bond or bond funds to interest rate changes. With greater modified duration,the bonds have higher price volatility than the bonds with lower durations.

An upward shift in the yield curve or normal yield curve is one in which longer maturity bonds have a higher yield compared to shorter-term bonds due to risks associated with time. An upward sloping curve suggeststhat financial markets expect short term interest rates to rise in the future. Thus,the net position gets increased during a upward shift in the yield curve.