LOS a: Distinguish between the full valuation approach (the scenario analysis approach) and the duration/convexity approach for measuring interest rate risk and explain the advantage of using the full valuation approach.

Which of the following approaches in measuring interest rate risk is most accurate when properly performed?

A) Full Valuation approach.

B) Duration approach.

C) Duration/convexity approach.

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There are three features that determine the magnitude of the bond price volatility:

1. The lower the coupon, the greater the bond price volatility.
2. The longer the term to maturity, the greater the price volatility.
3. The lower the initial yield, the greater the price volatility.

In this case the only determinant that will cause a higher interest rate risk is having a low yield to maturity (initial yield). A higher coupon yield and a higher current yield will cause for lower interest rate risk.

The most straightforward approach method for measuring interest rate risk is the so-called full valuation approach. Essentially this boils down to the following four steps: (1) begin with the current market yield and price, (2) estimate hypothetical changes in required yields, (3) recompute bond prices using the new required yields, and (4) compare the resulting price changes.