Question

"We can use duration to get a good estimate of the change in the price of a bond for a given change in yield."

Is this statement true or false? Explain.

Answer 1

Duration of a bond measures the interest rate sensitivity of the bond. For a given change in yield it tells us how much the price of the bond will move. Duration is measured in years. So for example if a duration of a bond is given as 5 years, it tells us that for a 1% decrease in yield, the price will increase by 5 and vice versa. Duration changes with time,yield or coupon rates.

However the biggest flaw of duration is that it is a linear measure of risk. That is it tells that the bond price will move up or down by the same amount for a percent change in yield. In practice however there is a convex relation between bond price and yield to maturity. The increase in the bond price for a significant Change in yield is higher than the decrease in bond price for the same change in yield in upward direction. So duration cant tell us this price change due to convexity, and that's where we use the derivative of duration which is known as Convexity.

So, we can say that duration is not always a good measure of price sensitivity.so the statement is false