Effective duration and convexity, Financial Management

Effective Duration and Convexity

The modified duration is a measure of the sensitivity of a bond's price to interest rate changes; the assumption made here is that the expected cash flow does not change with the interest rates. In the case of a callable bond, the cash flow does change with the interest rates. Then modified duration may not be appropriate to measure the price volatility of such bonds. If the rate of interest falls, the expected cash flow for a callable bond may change. Thus it may be concluded that modified duration is not an appropriate measure of price sensitivity to interest rate changes.

If P0 is the initial price and P1 is the price level to which it is reduced on account of a small increase in the yield (Dy) and the price increases to a level of P2 on account of a small decrease in the yield (Dy) then the approximate duration is given by the formula,
Approximate duration = 1942_Effective Duration and Convexity.png

where y is used in the decimal form. It can be observed that the formula measures the average percentage price change relative to the initial price per basis point change in the yield.

When this formula is used for a non-callable bond, it gives the modified duration since there is no change in the cash flow due to change in the yield. But when this formula is used for a callable bond, i.e., a bond embedded with an option, the new prices at the higher and lower yield levels should reflect the value from the valuation model. Duration calculated in this method is called effective duration or option-adjusted duration.

We may summarize the relationships among the duration, modified duration and the effective duration on the following lines:

  • Duration is a generic concept that indicates a bond's response to a change in interest rates.
  • Modified duration is a measure of duration in which it is assumed that the cash flows do not change with change in the yield.
  • Effective duration measures the sensitivity of the bond's price considering that the expected cash flows change on account of changes in the yield due to the option available with it.

 

Posted Date: 9/10/2012 8:18:42 AM | Location : United States







Related Discussions:- Effective duration and convexity, Assignment Help, Ask Question on Effective duration and convexity, Get Answer, Expert's Help, Effective duration and convexity Discussions

Write discussion on Effective duration and convexity
Your posts are moderated
Related Questions
7. Bill Peters is the investment officer of a $60 million pension fund. He has become concerned about the big price swings that have occurred lately in the fund’s fixed income sec

Acquisition (takeover) or merger A merger is the synergy or combination of two companies which are roughly equal in size by consensus of two organisations. A takeover is where

should a company pursue price hike or focus on increased sales

Advantage of mutual funds Mutual Funds are advantageous to individual investors in relation to their direct involvement in investment portfolio activity covering the following

It is the exercise price at which the investor or the bondholder exchanges the bond for shares.

Q. What is Unsystematic Risks? Unsystematic Risks stems from a managerial inefficiency, technological change in the production process, availability of raw material, changes in

Q. What is the rationale of the double-play strategy? Hedge Fund enters agreement to sell HK$ in six month's. At expiration the Hedge Fund requires to buy spot HKD and deliver

Should a company pursue price hike or focus on increasing sales volume

Explain Composite Currency Bond Composite currency bonds are denominated in a currency basket, like SDRs or ECUs, in place of a single currency.They are often known as currency

State the second element of capital budgeting decision The second element of capital budgeting decision is the analysis of risk and uncertainty. As the benefits from investment