Limitations of key rate duration analysis

Key rate durations are a popular and powerful tool for managing non-parallel risk,
so it is important to understand their shortcomings.
First, key rate durations can be unintuitive. This is partly because ‘tent’ shifts do
not occur in isolation, and in fact have no economic meaning in themselves. Thus,
using key rate durations requires some experience and familiarization.
Second, correlations between shifts at different reference maturities are ignored.
That is, the analysis treats shifts at different points in the yield curve as independent,
whereas different yield curve points tend to move in correlated ways. It is clearly
important to take these correlations into account when measuring risk, but the key
rate duration methodology does not suggest a way to do so.
Third, the key rate duration computation is based on perturbing a theoretical zero
coupon curve rather than observed yields on coupon bonds, and is therefore sensitive
to the precise method used to strip (e.g.) a par yield curve. This introduces some
arbitrariness into the results, and more significantly makes them hard to interpret
in terms of observed yield curve shifts. Thus swap dealers (for example) often look at
partial durations computed by directly perturbing the swap curve (a par curve) rather
than perturbing a zero coupon curve.
Fourth, key rate durations for mortgage-backed securities must be interpreted
with special care. Key rate durations closely associated with specific reference
maturities which drive the prepayment model can appear anomalous; for example,
if the mortgage refinancing rate is estimated using a projected 10-year Treasury
yield, 10-year key rate durations on MBS will frequently be negative. This is correct
according to the definition, but in this situation one must be careful in constructing
MBS hedging strategies using key rate durations.
Fifth, key rate durations are unwieldy. There are too many separate interest rate risk measures. This leads to practical difficulties in monitoring risk, and inefficiencies
in hedging risk. One would rather focus mainly on what is ‘most important’.
To summarize: while key rate durations are a powerful risk management tool, it is
worth looking for a more sophisticated approach to analyzing non-parallel risk that
will yield deeper insights, and that will provide a basis for more efficient risk
management methodologies.