Question

6.         a)            What is duration? What is modified duration?

                b)            What is Macaulay’s duration?

                c)            What is crucial to formulating both active and passive strategies?

                d) How is immunization of a fully funded plan accomplished? What is a more direct form of

                                immunization?

7.            a) Consider an economy where the dominant industry is automobile production for

domestic consumption as well as export. Now suppose the auto market is hurt by an increase in the length of time people use their cars before replacing them. Describe the probable effects of this change on (i) GDP, (ii) Unemployment, (iii) The government budget deficit, and (iv) Interest rates.

b) Suppose the government wants to stimulate the economy without increasing interest rates.   What combination of fiscal and monetary policy might accomplish this goal?

c) Hypothetically, large tax cuts in 2001 were followed by relatively rapid growth in GDP. How would demand-side and supply-side economists differ in their interpretation of this phenomenon?

d) In which of the business cycle would you expect the following industries to enjoy their best performance? (i) Newspaper, (ii) Machine tools, (iii) Beverages, (iv) Timber.

Answer 1

Ans: Duration :Duration is a measure of change in pricing of an investment as per the change in interest rates. Like with 1 bps change in interest rate would change the price of an instrument by x value.

Macaulay duration : It is the weighted average term of cash flows from a bond to maturity. We can say that PV of each cash flow is to be summed up and divide it by the market price of the instrument.

Modified duration : It assumes that bond prices and interest move in opposite direction. It s Macaulay duration/(1+YTM/n) here YTM = yield to maturity and n = no. of periods.

Macaulay duration counted as no. of years while Modified duration counted as change in price and treated as function of yield.

c) Capital market efficiency and risk apetite is very crucial to define the active or passive strategy.

d) Immunization is a method to balance the assets and liabilities duration , it will reduc or minimize the change in interest rate on balance sheet. It is accomplished by providing the short duration liability covered by short duration asset or sometime long term also.

More direct form of immunization is dedicated portfolio for each specific kind of liability to be taken care of at the time of maturity to avoid and deficit or liquidity situation.