Question

Two investors, Drew and Sidney, are investing in fixed income assets. Drew has a fixed income portfolio worth $5000 with a duration of 10 years. Sidney has a fixed income asset portfolio worth $8,000 with a duration of 5 years. Interest rates just jumped up by five basis points today. Which investor’s portfolio saw a larger dollar loss?

(a) Drew’s.

(b) Sidney’s.

(c) Unclear, depends on the maturity of the bonds in the respective portfolios.

(d) Unclear, depends on the current level of interest rates.

Answer 1

Correct answer is (a) Drew's

If interest rates rise by five basis points, Drew would lose by 10 years *50 basis points i.e., 500 bp whereas Sidney would lose by 5 years *50 basis points i.e., 250bp. The shorter a bond’s duration, the less volatile it is likely to be and the longer the bond duration, the more volatile it is likely to be.

For example, a bond with a 1-year duration would only lose 1% in value if interest rates rises by 1%. However, a bond with a duration of 10 years would lose 10% if interest rates rise by 1% and the vice-versa holds true.