Effective duration and convexity, Financial Management

Assignment Help:

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.

 


Related Discussions:- Effective duration and convexity

Total return for a mortgage-backed and asset-backed security, The ...

The total return in case of mortgage-backed and asset-backed securities depend on the projected principal repayment and the interest earned on r

Dividend yield method, Dividend yield method As per this method, the co...

Dividend yield method As per this method, the cost of Equity capital is the discount rate that equates the present value of expected future dividends per share with the net pro

Asset depreciation range, Work out and submit the comprehensive problem bel...

Work out and submit the comprehensive problem below. Halstrom Corporation purchased a piece of equipment three years ago for $230,000. It has an asset depreciation

Graphical method, The graphical method is a simple one, and is the mo...

The graphical method is a simple one, and is the most easily understood of the several linear programming methods. A thorough knowledge of the graphical procedure

What is investment decision, Q. What is Investment Decision ? Investmen...

Q. What is Investment Decision ? Investment Decision: - Investment decision as well known as 'Capital Budgeting' is related to the selection of long-term assets or projects in

Define stress testing and leverage, Lehman Brothers Holdings was a global f...

Lehman Brothers Holdings was a global financial services firm which, until declaring bankruptcy in 2008, participated in business in investment banking, equity and fixedincome sale

Day count convention, Day count convention is a system used to determ...

Day count convention is a system used to determine the number of days between two coupon dates. It is important in calculating accrued interest and present value

Riskiness of portfolios b/w riskiness of individual asset, Why does the ris...

Why does the riskiness of portfolios have to be looked at differently than the riskiness of individual assets? The riskiness of portfolios has to be seemed to be at differently

Calculate the minimum price sell for in a rational market, Suppose spot Swi...

Suppose spot Swiss franc is $0.7000 and the six-month forward rate is $0.6950.  What is the minimum price which a six-month American call option along with a striking price of $0.6

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