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

Highest earnings-per-share, McGovern Company is comparing two disimilar cap...

McGovern Company is comparing two disimilar capital structures - an all-equity plan (Plan I) and a levered plan (Plan II).  Under Plan I, the Company would have 700,000 shares of s

NPV, Roxanne invested $560,000 in a new business 7 years ago. The business ...

Roxanne invested $560,000 in a new business 7 years ago. The business was expected to bring in $8,000 each month for the next 26 years (in excess of all costs). The annual cost of

Define the primary reasons that companies hold cash, What are the primary r...

What are the primary reasons that companies hold cash? Companies hold cash to make essential payments, to take benefit of opportunities as they arise, and to cover unforeseen eme

Convexity, Duration is good measure while estimating the percentage p...

Duration is good measure while estimating the percentage price change for a small change in interest rates but the estimation becomes inferior with the larger cha

What is the financial leverage effect and what causes it, What is the finan...

What is the financial leverage effect and what causes it?  What are the potential benefits and negative consequences of high financial leverage? Monetary leverage is the additi

Characteristics of warrants, Characteristics of Warrants As mentioned e...

Characteristics of Warrants As mentioned earlier, a warrant is a variant of a call option and gives the holder a certain right to purchase shares of the company at a predetermi

Accounting principles board, Q. Accounting Principles Board ? Accountin...

Q. Accounting Principles Board ? Accounting Principles Board (APB) -senior technical committee of AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS (AICPA) that issued pronoun

Finance manangement, What is the maximum price that you would be willing to...

What is the maximum price that you would be willing to pay for a constant growth stock that has the following characteristics: (a) Dividend (Has Paid): $3.25, (b) Growth: 7%, and (

Ledgers, Ledgers: Ledgers record all the entries into the Cash Books. T...

Ledgers: Ledgers record all the entries into the Cash Books. They use the concept of 'double entry' bookkeeping where every ledger entry must be accompanied by another ledger e

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