Modified duration versus effective duration, Financial Management

Assignment Help:

Modified duration is used to determine the percentage change in the bond's prices for a 100 basis point (1%) change in the yield. The underlying assumption is that the bond's expected cash flows would not change when yield changes. It means that to calculate the value of V- and V+ in equation (1) the same cash flows used for calculating V0 are used.

The assumption that cash flow would not change when yield changes is not true for all types of bonds. It is true in case of option-free bond but it is not applicable in case of putable and callable bonds. For example, the payments made by the Treasury Department to the holders of its obligations do not change when interest rates change. However, the same is not true for bond with embedded options. The expected cash flows may change significantly with the change in the yield.

Effective duration is a duration calculation for bonds with embedded options. Effective duration takes into account both the discounting at different interest rates and how the expected cash flow may change. Effective duration can be estimated using modified duration if the bond with embedded options behaves like an option-free bond. This behavior occurs when exercise of the embedded option would offer the investor no benefit. As such, the security's cash flows cannot be expected to change given a change in yield.   There can be huge difference between the modified duration and effective duration. For example, the modified duration for a callable bond could be 7, whereas the effective duration could be 5. Sometimes it may be the other way round, i.e for certain mortgage obligations the effective duration may be more than the modified duration. Therefore, we can conclude that the effective duration is a more appropriate measure in case of bonds with embedded options.


Related Discussions:- Modified duration versus effective duration

Explain banks circumtances to impose compensating balances, What are compen...

What are compensating balances and why do banks require them from some customers?  Under what circumstances would banks be most likely to impose compensating balances? Compensa

Determination of spread, Determination of spread Daily interest rate = ...

Determination of spread Daily interest rate = 5.11/ 365 = 0.014% per day Variance of cash flows = 1000 × 1000 = $1000000 per day Transaction cost = $18 per transaction

Resource acquisition and resource planning, 1. List five different types of...

1. List five different types of resource that a company might consider hiring or leasing. Explain why the might choose these option instead of outright purchase 2. List three di

Accounting, Accounting : Many people believe financial management only r...

Accounting : Many people believe financial management only relates to bookkeeping and the establishment of accounting reports which reflect those transactions in the books.  Whi

Evaluation of credit policy, Q. What is Evaluation of Credit Policy? Ev...

Q. What is Evaluation of Credit Policy? Evaluation of Credit Policy: - A credit policy is prepared to maintain the investment in receivables at optimum level. Receivable Turnov

Explain the term- maturities, Explain the term- Maturities Debentures a...

Explain the term- Maturities Debentures are sometimes grouped by length of time till maturity that existed on the date debenture was first issued.  Money Market Securities matu

Explain demerits of accept-reject criteria, Q. Explain demerits of accept-r...

Q. Explain demerits of accept-reject criteria? Demerits of ARR:- (i) It utilizes accounting income rather than cash flows: - The principal short coming of ARR schema is th

Evaluation of bids, E v aluation of  bids and determination of the lowes...

E v aluation of  bids and determination of the lowest  evaluated responsive and qualified bidder You learnt how to receive and open bids in the previous sub section. Here you

Surplus economic unit deal with a deficit economic unit, What can a financi...

What can a financial institution often do for a surplus economic unit that it would have difficulty doing for itself if the surplus economic unit (SEU) were to deal directly with a

Distinguish between diversifiable and non-diversifiable risk, Question: ...

Question: (a) An efficient financial market is assumed to hold under the Capital Asset Pricing Model (CAPM). What is the main hypothesis of an efficient financial market? (

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