Explain what makes bonds more sensitive to discount rate changes, and how Duration measures bond sensitivity....

Explain what makes bonds more sensitive to discount rate changes, and how Duration measures bond sensitivity. Why does higher Duration mean greater sensitivity, and lower Duration less (explain by using the equation, in terms of the present value of the coupon and principle payments)?

Expert Solution

Bonds are reacting to changes in the discount rate and those bonds who are having a higher duration will be having a higher sensitivity towards changes in the discounting rate and those bonds who have a lower duration will be having a lower sensitivity towards changes in the discount rate and it is also associated with the coupon rate which are paid on the bonds because the higher coupon bonds will be not affected much by changes in the discounting rate but lower coupon bonds are having a high degree of sensitivity towards any change in the prevailing rate of interest in the market.

Bonds which are having a higher duration have a higher sensitivity towards any changes in the discounting rate because they will be liable to to bear the changes for the longer period of time and they will be having a a high degree of exposure related to the duration and the bond holder will be having a high exposure because of high duration to any kind of changes in the discounting rate whereas the bonds that will be having a lower duration will be having a lower sensitivity because the bond holder will be having a lower exposure to the overall changes due to his lower time period and lower maturity.

Present value of all the periodic payments in the form of coupons will be reduced by higher discounting rate and those bonds who are having a higher duration will be getting affected by changes in the discounting rate for the longest time period.

Present value of bonds receipts in the form of interest and principal will be having another aspect that principal will be repaid at the end and it will mean that discounting rate will be affecting the principal with the higher duration as they will be impacting the overall receipt at the the larger time frame.

Pv= cash flows/(1+I)^n

when we will be discounting the cash flows at the present using discount rate, then we will be e getting impacted by the discounting rate for a longer maturity if the bond has a longer duration.

jeff jeffy answered 1 year ago

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