Which of the following is true about duration and modified duration? I. The Macaulay duration calculates...

Which of the following is true about duration and modified duration? I. The Macaulay duration calculates the weighted average time before a bondholder would receive the bond's cash flows.
II. Modified duration measures price sensitivity of a bond to changes in YTM by adjusting duration with a factor based on current yield.
III. The value of duration and modified duration are usually very close, but duration is almost always a larger number.A.Duration is important to banks when they try to assess the risk of bond portfolios on their balance sheet.

A. Only I and II are true. B. All but IV are true. C. Only II and III are true. D. All are true. E. What's duration?

Solutions

Expert Solution

Option D

Modified duration

Let’s say I am a stockist of winter clothes such as sweaters and mufflers. In anticipation of a good winter, I have stocked clothes in excess. My biggest concern is whether I will be able to sell all these before the onset of summer Let’s say if the summer steps in earlier than expected, then what do I do? Naturally to clear the stock I will have to lower its price. Contrary, if for some reason the winter gets more severe and prolonged, then what could happen? In such a situation I will charge a premium for the goods that I have in stock and since I have a large supply, I would therefore make more money.

Thus, the behavior of an external factor seems to be having a major impact on the prices I charge in the market. Now keep this in mind as I attempt to explain “modified duration” for debt products.

Modified Duration by definition expresses the sensitivity of the price of a bond to a change in interest rate.

jeff jeffy answered 1 year ago

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