Question

**Duration Problems**

1. Why is it important to be able to estimate the duration of a bond or a bond portfolio?

2. Explain why you agree or disagree with the following statement: "Determining the duration of a financial asset is a simple process."

3. Explain why the effective duration is a more appropriate measure of a complex financial instrument's price sensitivity to interest rate changes than is modified duration.

Answer 1

1. It is important to estimate the duration since the duration of the bond will help us determine whether the investors should sell or buy a bond of a particular duration. In a rising interest rate scenario, higher yields will drive down the prices of long term bonds. So, in a rising interest rate cycle, investors should sell long duration bonds and buy shorter duration bonds. On the other hand, in a falling interest rate cycle, the investors can sell shorter duration bonds and buy long duration bonds.

2. No, I do not agree with the given statement. Determining duration of an asset is not a simple process. It is because when interest rates change, the cash flows also change drastically and this calculation becomes complex. If we make its simple and not consider this change in cash flows, duration makes no sense.

3. It is for the same reason as stated in answer to #2 that modified duration is not appropriate. Modified durations assumes that cash flows are constant and do not change when interest rates change. However effective duration considers this change which is true in reality. Most financial assets have price sensitivity when the interest rate changes. For example in bonds, there is inverse relationship between bond prices and interest rates.