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

Assignment, Hi, what is your time limits on providing solutions

Hi, what is your time limits on providing solutions

Explain economic exposure to exchange risk, How would you explain economic ...

How would you explain economic exposure to exchange risk? Answer: Economic exposure can be illustrated as the opportunity that the firm’s cash flows and so its market value may

Future value of an annuity, Will you please give the defination of "Future ...

Will you please give the defination of "Future Value Of An Annuity"?

Discuss the importance of dividend decisions, 1.   Discuss the various tech...

1.   Discuss the various techniques of inventory management for efficient working capital management. 2.   Discuss the importance of dividend decisions. What is MM theory of div

What was the first argument against traditional approach, What was the firs...

What was the first argument against traditional approach The first argument against traditional approach was based on its emphasis on issues relating to procurement of funds by

Define how the market determine the fair value of a bond, How does the mark...

How does the market determine the fair value of a bond? The bond’s fair value is the present value of the bond's coupon interest payments plus the present value of the face value

What is bid, Bid The price buyers provide to acquire securities or pri...

Bid The price buyers provide to acquire securities or privacy from sellers.

What is the value of ast stock, Brandon Michael Chu of Henry Law & Yang Yi ...

Brandon Michael Chu of Henry Law & Yang Yi Capital Limited believes that earnings and dividends at Alua Amanova & Shuwen Wang Technologies (AST) will continue to grow at 12% per ye

What do you mean by cash flow ratios, Q. What do you mean by Cash Flow Rati...

Q. What do you mean by Cash Flow Ratios? Cash Flow Ratios: - Cash Flow Ratios are an additional device of cash management. Some important cash flow ratios are: (i) Cash Turn

Asset Securitization Structures (Excel help), #questAs an assistant vice pr...

#questAs an assistant vice president at a regional bank, your boss has tasked you to acquire $100 million of residential mortgages to be securitized in a pass-through MBS. There mu

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