Rate changes and duration estimate, Financial Management

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To calculate duration, we need to first obtain the values for V- and V+ where V- is the price when the yield decreases by certain number of basis points and V+ is the price when the yield increases by same number of basis points. However, the question is how much should be used to shock the interest rates up and down. While calculating duration estimates for option-free bonds the size of shock is not important. But when we deal with complex securities, like bonds with embedded options, even small rate change may change the expected cash flows and as a result determining the price change may not be possible. In case of large rate shocks, it may cause dramatic changes in the expected cash flows. Another draw back of using small changes in interest rate.  The prices used for calculations are based on valuation model. If the valuation model  used is poor, the prices calculated using that valuation model would also be a poor price estimate. When such estimates are divided by small shock in the rates in the denominator, there would be a significant effect on the duration estimate.


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