Question

9.         When bond price change measured by duration is not effective and why?

Answer 1

Answer: Bond duration - It is a measure of sensitivity of the price of the bond and interest rate. Duration helps in predicting the change in the price of a bond with respect to change in interest rate. For every 1% increase or decrease in interest rate, bond price will change 1% (approx) in the opposite direction for every year of duration. Duration measures the time that takes a bond to repay the principal to the bondholder. Higher the duration, the more price will drop if interest rate rises and will have a higher interest rate risk.

A bond's term is linear measure of the years until repayment is due, it does not change with the environment of interest rate. Duration is a non linear and increases as the time to maturity decreases. Duration assumes that there is linear relationship between interest rate and bond price but actually the relationship is curvilinear. When there is more convex the relationship between interest rate and bond price, the more inaccurate duration is for measuring interest rate sensitivity.