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

Asset-backed securities, Introduction When financial assets...

Introduction When financial assets or bonds are pooled together and offered to the investors for receiving the inflow of funds from these underlying

Application of shareholder value maximization framework, Application of Sha...

Application of Shareholder Value Maximization Framework   Factors affecting Shareholder's Value are: Capital Market Conditions Profitability à Includes factors li

Preparing the divestiture, Preparing the Divestiture No two divestiture...

Preparing the Divestiture No two divestitures are exactly alike and one of the foremost tasks of the project team is to determine precisely what is to be sold. While some dives

Finance for managers, Before tax cost of debt and after tax cost of debt; ...

Before tax cost of debt and after tax cost of debt; Personal finance problem. David Abbot is interested in purchasing a bond issued by Sony. He has obtained the following inform

Statement of total comprehensive income, At 31 July 2010 this instrument me...

At 31 July 2010 this instrument meets the definition of a derivative: Small or no initial investment. Its value is dependent on an underlying economic item; exchange ra

Valuing zero-coupon bond, As we know, zero-coupon bonds are issued wi...

As we know, zero-coupon bonds are issued without any periodic coupon payments. The investor gets the interest and the principal on a maturity date. The interest i

Explain the term - yield to call, Illustrate the process of calculating cal...

Illustrate the process of calculating call/ put options yields Issuing corporation will use provision if interest rates fall substantially below coupon rates offered on the se

Issuer’s considerations, Issuer's Considerations Cash Flows: Issuers ma...

Issuer's Considerations Cash Flows: Issuers may consider the period for which the funds are required and try to spread the borrowings in a way to minimize the costs. Generally,

Return on equity, Your quantitative analysis will describe the financial st...

Your quantitative analysis will describe the financial strength of you company using the metrics we discussed in class. You may use other measures at your discretion, but the follo

Can you explain about finance function, Q. Can you explain about Finance fu...

Q. Can you explain about Finance function? Finance function is the most important function of the all business function. It remains a focus of the all activity. It is not possi

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