A bond is a loan. When you buy a bond, you pay at the current price of the bond in exchange for the periodical interest payments, or “coupon payment”, and return the par value of the bond at a specified term. For example, a 10-year, 6 percent bond at $1,000 face value will pay you $60 a year in interest until maturity for 10 years and then pay you $1,000 in the denomination. The interest rate sensitivity that measures the price of a bond will change due to interest rate changes, which is important if you are going to sell the bond ahead of time. On the maturity date, the price will always be in the denomination.
To understand the sensitivity of the exchange rate, you must first understand how interest rates affect bond prices. A typical bond pays a fixed amount of interest per year, known as an annual coupon, until maturity. If the current interest rate rises after the bond are issued, the newer bond will pay a higher interest rate than the older one. Since old bonds are now less popular than new bonds, their price will fall. Here’s the general rule: When interest rates go in one direction, bond prices go the other way. Interest rate sensitivity shows you how much the bond price will change.
Another important term to understand is productivity. The current yield of a bond is its annual interest rate divided by its current price. If the current price is in denomination, which usually occurs for newly issued bonds, then the yield is equal to the fixed interest rate of the bond. A 6 percent bond at $1,000 and a $1,000 price would have a current yield of 6 percent. Higher prices will reduce productivity; lower prices will increase output. For example, if the price drops to $960, the income will rise to $60/$960, or 6.25 percent.
There are several ways to measure interest rate sensitivity. A set of related calculations, called duration, requires a lot of calculations. But you can estimate the sensitivity well by remembering that if interest rates change by 1 percentage point, bond prices will change in the opposite direction around 1 percent per year until maturity.
Consider what will happen, if the current interest rate rises by 1 percentage point, for bonds with a 10-year term until maturity and the current yield of 6%. Bond prices will fall 4 percent, which is the sum of a 1 percent year-on-year decline plus a current yield of 6 percent, or [(-0.01/year 10 years) + 0.06]. If the bond price is $1,000, its new price after an interest rate increase will fall (-0.4 $1,000) or $40, to $960.
By comparing the sensitivity of different bonds to the change in interest rates, you know how much you affect the sudden changes in the current interest rate. For example, if you worry that interest rates may rise, you can opt for shorter-term bonds, as they are less sensitive. If the sample bond has a maturity period of 3 years and a yield of 2 percent, the bond will take only [(-0.01/year*3 years) + 0.02] or -1 percent, with a new price of [$1,000+ ($1,000 *-0.01)] or $990.