Calculating Effective Duration for Securities with Uneven Cashflows and Prepayment Risk.

CFA General
#1

I am attemping to calcualte effective duration for a portfolio of mortgages (some of which have uneven cashflows, and prepayment options).

Does anyone have any experience with this?

Thanks,

Nigel

#2

I spent six years developing prepayment models for mortgages at a little fixed income shop in Newport Beach, CA, so I have some experience with it.

What would you like to know?

#3

First question: Say you are trying to calculate the duration of a mortgage fund; would you use effect duration or modified duration + convexity adjustment (I dont know if thats even possible in excel)?

#4

You have to use effective duration. Recall that modified duration (and modified convexity) assumes that the cash flows do not change, whereas effective duration (and effective convexity) allow that the cash flows can change.

A few years ago I developed a bond market simulation program (in Excel) that is used in a Fixed Income course at UC, Irvine. (I’m hoping to pretty it up a bit and to market it to other universities.) Amongst the securities I have are MBSs, so I had to model prepayments in Excel to compute effective duration and effective convexity. It’s a relatively simple model (it’s only a simulation, after all), but certainly more complex models are possible.