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

Rating methodologies of a debt instrument, The key parameters t...

The key parameters taken into account while rating a debt instrument are as follows: 1. Industry Evaluation - This involves an evaluation of the

Explain about the debt policy, Explain about the debt policy Designing...

Explain about the debt policy Designing debt policy the debt policy of a firm is significantly influenced by the cost consideration. In designing financing policy, that is, p

Operating cycle, applicability of an operating cycle in a vegetable growing...

applicability of an operating cycle in a vegetable growing business

Answer, The standard cost of chemical mixture ~ PQ’ is as follows: 40% of m...

The standard cost of chemical mixture ~ PQ’ is as follows: 40% of material P @ Rs. 400 per kg. 60% of material Q @ Rs. 600 per kg. A standard loss of 10% is normally anticipated in

Emerging market bonds, Emerging market bonds are the bonds offe...

Emerging market bonds are the bonds offered by less developed countries. The government normally issues them. These exclude borrowings from gove

Trading Options, TRADING IN OPTIONS We have already seen that options a...

TRADING IN OPTIONS We have already seen that options are traded on exchanges and have already discussed how to understand published quotations. Let us now learn the trading mec

Debt finance, Ask queswtion #Minimum 100 words accepted# what are the chara...

Ask queswtion #Minimum 100 words accepted# what are the characteristics of debt finance? What are the similarities and differences between debt finance and ordinary share capital

Determination of values price and volume, Determination of values The v...

Determination of values The values for which NPV turns into zero are found by calculating the break-even values for the selected variables. Once determined these give an indica

Cash discount, Which one is true 1.the higher the discount rate the lower ...

Which one is true 1.the higher the discount rate the lower the cost of trade credit 2.the higher the discount rate the higher the cost of trade credit 3.cost of trade credit duri

What are the operating and financing decisions of any firm, A firm's operat...

A firm's operating and financing decisions   Risk also results from decisions made within the company.  This risk is usually divided into two classes:  - Business risk is th

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