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

Does high operating leverage always mean high business risk, Does high oper...

Does high operating leverage always mean high business risk?  Explain. High operating leverage does not all the time mean high business risk.  If the companies sales are quite

What do you mean by business risk, Q. What do you mean by Business Risk? ...

Q. What do you mean by Business Risk? Business risk is that portion of the unsystematic risk caused by the operating environment of the business. Business risk arises from the

Find NPV of 2 Projects, Woody Construction is considering a new 3-year expa...

Woody Construction is considering a new 3-year expansion project that requires an initial fixed asset investment of $3.186 million. The fixed asset will be depreciated straight-lin

Capital investment plans , Report based on Capital Investment Plans   ...

Report based on Capital Investment Plans   To analyze the capital investment plans of Hatsun Agro Products Limited (HAPL) we shall look at the capital expenditure of HAPL in

Compare the ifrs and gaap revenue recognition policies, SUPERVALU INC . ...

SUPERVALU INC . , a large US retail grocer, had $36.1 billion in sales for its fiscal year ended February 25, 2011. SUPERVALU currently reports using US GAAP. The controller of

Laspeyres method, Laspeyres Method Laspeyres method uses the quantities...

Laspeyres Method Laspeyres method uses the quantities consumed during the base period in computing the index number. This method is also the most commonly used method which inc

Difference among currency forward market and futures market, Explain the ba...

Explain the basic differences between the operation of a currency forward market and a futures market. Answer:  The forward market is an OTC market in which the forward contract

What do you meant by common stocks in the financial term, What do you meant...

What do you meant by common stocks in the financial term? Common Stocks: Common stocks illustrate ownership interests into the firm. Common stockholders obtain dividends (wh

Forecasting yield volatility, There are several methods available to ...

There are several methods available to forecast yield volatility. But before that, let us look into the calculation of forecasted standard deviation. Assume th

Major risk return decision areas, Q. Major Risk Return Decision Areas? ...

Q. Major Risk Return Decision Areas? 1) Financial Analysis and Control: This area is concerned with the Financial Statements, i.e. Income Statement, Balance Sheet, Funds Flow S

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