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

Frankfurt stock exchange, Frankfurt Stock Exchange The roots of the Fran...

Frankfurt Stock Exchange The roots of the Frankfurt Stock Exchange may be traced back to the period of medieval fairs. As early as the middle of the ninth century, Emperor Ludwi

Portfolio Management, Portfolio Project The purpose of this project is to h...

Portfolio Project The purpose of this project is to help you to gain an understanding of how the stock market works and of the relationship between theory and practice. You are gi

Which ratios is potential long term bond investor, Which ratios would a pot...

Which ratios would a potential long-term bond investor be most interested in? Explain. Potential and Current lenders of long-term funds, like banks and bondholders, are interest

Market segmentation of the term structure of interest rates, Define the mar...

Define the market segmentation of the term structure of interest rates. Market segmentation: And also the investors’ expectations regarding future interest rates and thei

Time value of money, TIME VALUE OF MONEY Time value of money can be de...

TIME VALUE OF MONEY Time value of money can be described as the value of a unit of money at different time periods.  It involves that the value of a unit of money is not same

Statement used in working capital requirement, • Debtors :- Working Capi...

• Debtors :- Working Capital tied up in debtors must be estimated on the basis of cost of sales (excluding depreciation): [Cost of goods produces (that is raw materials + wages

Assessment of in individual strengths and weaknesses, Assessment of in indi...

Assessment of in individual strengths and weaknesses Before finalizing career plan for an individual and placing him on career path, it is necessary to access his strengths and

Accounting framework - convention of consistency, Accounting Framework  - ...

Accounting Framework  - Convention of Consistency This doctrine denotes that accounting rules, practices & conventions should be continuously observed and applied that implies

Capital structure definition, CAPITAL STRUCTURE DEFINITION According to...

CAPITAL STRUCTURE DEFINITION According to Gerstenberg, Capital structure refers to 'the makeup of a firm's capitalisation'.  In other way, it signifies the mix of different sou

Importance of a sinking fund, "The emphasis on the practice of good corpora...

"The emphasis on the practice of good corporate governance has brought about more negative than positive implications to public-listed companies". Do you agree with the above st

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