Movements in the Term Structure of Interest Rates

TLDR

Bond prices move together while stocks move independently, necessitating distinct risk‑management strategies for each asset class. The article reviews and extends prior work by decomposing term‑structure movements into level, slope, and curvature components. The authors model interest‑rate behavior to balance portfolios and hedge systematic risk factors, contrasting with equity diversification to reduce idiosyncratic risk. Empirical analysis shows that the factor structure has remained stable since 1970, and factor‑based hedging outperforms traditional Macaulay‑duration hedging.

Abstract

Bond prices tend to move together. Stocks tend to go their own way. This distinction requires completely different approaches to managing risks for these securities. For equities the emphasis is on reducing idiosyncratic risk through portfolio diversification. For interest rate-sensitive securities it is on precisely balancing a portfolio to achieve the desired exposure to systematic risk factors. ; Hedging to reduce or eliminate the common factors influencing an interest rate-sensitive portfolio's value requires a model of interest rate behavior. This article reviews and extends previous studies showing that term structure movements can be decomposed into three components-changes in the general level of interest rates, changes in the slope of the term structure, and changes in the curvature of the term structure. It presents empirical analysis showing that since 1970 the structure of these factors has not changed appreciably even though interest rate volatility has. The author provides a numerical example demonstrating that hedging based on the factor decomposition is superior to hedging based on the traditional method of Macaulay duration.