Cash flow duration, Financial Management

Assignment Help:

Cash flow duration, like effective duration, considers the change in the cash flow due to prepayment with the change in the interest rate. In effective duration, cash flows are calculated using the  Monte Carlo method, but in cash flow duration the cash flows are calculate using static methodology. Following are the steps followed to calculate cash flow duration:

  1. Cash flows are calculated based on some prepayment assumptions.

  2. Using the calculated cash flows and the market price (P0), the cash flow yield is computed.

  3. Cash flow yield is then increased by Δ y and the new prepayment rate at that higher cash flow yield is determined from a prepayment model. The prepayment rate would be lower because of the higher yield.

  4. Using this lower prepayment rate, we can arrive at cash flow and the value of the cash flow using the higher cash flow yield as the discount rate (P+).

  5. Similarly, cash flow yield is decreased by Δy  and the new payment rate at lower cash flow yield is calculated. Then, using this higher prepayment rate, cash flow and the value of the cash flow using the lower cash flow yield as the discount (P-) is calculated.

Once we calculate P+ and P-, we can calculate the duration using the general formula of duration i.e.,

         Duration =  980_cash flow duration.png

When we compare modified duration, effective duration and cash flow duration, modified duration is considered inferior to that of cash flow duration. This is because modified duration ignores the changes in prepayment due to interest rate changes. Cash flow yield is based on naïve assumption about how prepayments may change; in contrast,  Monte Carlo simulation model is based on more sophisticated analyses of how the cash flow can change when interest rates change. The effective duration computed using  Monte Carlo method is considered superior to cash flow duration.


Related Discussions:- Cash flow duration

Marshall-edgeworth method, Marshall-Edgeworth Method Marshall-Edgeworth...

Marshall-Edgeworth Method Marshall-Edgeworth method uses both the current year as well as the base year prices and quantities. Marshall-Edgeworth Index can be computed using th

PROFIT MAXIMIZATION, what are the arguments in favour of profit maximizat...

what are the arguments in favour of profit maximization?

Walter''s Model, Explain the effect of different dividend policies on the v...

Explain the effect of different dividend policies on the value of share respectively as per the walter model in Case 1: Dividend payout ratio is 50% Case 2: Dividend payout ratio

Gold standard, what is the traditional gold standard? and how does it diffe...

what is the traditional gold standard? and how does it differ from our current monetary system.

ACCRUAL INCOME VERSU CASH FLOW, Thomas book sales, inc. supplies texbooks t...

Thomas book sales, inc. supplies texbooks to college and university bookstore. The books are shipped with a proviso that they must be paid for within 30 days but can be returned f

Define why it is difficult to forecast future exchange rates, Researchers f...

Researchers found that it is extremely difficult to forecast the future exchange rates more precisely than the forward exchange rate or the current spot exchange rate. How would yo

Standard deviation for every project, AOT limited is considering two mutual...

AOT limited is considering two mutually exclusive projects - cable and satellite.  The possible NPVs for every project and their associated probabilities are as follows: Cable:

Need for credit and its nature, Need for Credit and its nature On the d...

Need for Credit and its nature On the demand side of the economy are the consumers of goods and services who require funds basically for acquiring certain consumer durables. Th

Shareholders'' wealth maximization, Shareholders' wealth maximization S...

Shareholders' wealth maximization Shareholders' wealth maximization refers to maximization of the net present value of every decision made in the firm. Total present value is e

Explain the factors which company should apply, Explain the factors which c...

Explain the factors which company should apply Companies to be the very best must Establish what competition is doing Set the very best standards to exceed Es

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd