Can someone help me w.r.t the Duration measure? I’ve seen both these scenarios When interest rates are “falling” We would want a high duration (say, a longer time to maturity because of a low coupon) i.e. Bond price would go up more (this one makes sense to me) But, I have also seen situations; When interest rates are “falling” We would want a low duration, why!? How should I make sense of this situation? I interpret it as “low volatility” In both situations Interest rates are FALLING, yet the Duration measure we desire is different? Or am I just not interpreting Duration correctly? I think of it as sensitivity/volatility I know this is wishfull thinking, but, Is there an approach to duration that I can use in these situations? Thanks all, this is wearing on me…
Almo you lost me at the Alamo. I haven’t seen any situations for your #2 scenario. If interest rates are falling, bond prices are rising, hence you want to increase your Duration so that your Bond prices rise more for a given level of interest rate decline. Unless sell a futures contract and interest rates are falling, then maybe that is why you would want lower duration…
I think you may want to reduce the duration if you fear the reinvestment income will reduce.
Thanks bigwilly, trymybest trymybest sort of sees where I’m coming from… I didn’t want to give too much away because it was on the Online sample exam. but one of the question stated that because short term rates were falling we would want a short (low) duration bullet strategy and I put high duration bullet strategy because 1, when interest rates are falling we do want high duration and 2, I said bullett strategy because obviously it has less reivestment risk. so with that said? how should I approach?
SPOILER…DON’T READ IF YOU HAVEN’T TAKEN SAMPLE EXAM #1 Oh I took that one. You took it out of context. It stated that ST interest rates were decreasing and LT interest rates were increasing. THUS, you wanted to go into a ST Bullet (ST Bond(s) at single maturity date) to benefit from the decrease in ST rates. It has nothing to do with Duration really. It’s more about where you want to position yourself on the yield curve. If you went with a LT bond you would lose money. If you went with a ST bond you would make money. If you went with a barbell that was say 50/50 in LT vs ST you might Gain or you might Lose depending on the durations, but in either case the gain will MOST LIKELY be less than a ST bullet.
Thanks bigwilly! I think I follow… but what about the reinvestment risk? Are we saying that Short term (and this is more prevalent with the Barbell Strategy) we will see bond prices go up, (i.e. paying more for each bond because maturities are earlier and hence more rollingover and out) and that the reinvestment of those “coupons” will be less? …so In a way it does mean you want/have a short duration because you have less reivestment risk around the horizon date for the Bullet (i.e. less maturities to rollover)
The text moves between Mac. Duration and Effective Duration, when it comes to referring to duration. I am using the following logic for myself. My take is that when I want my return to be higher, in light of expected falling rates, I would increase Duration (Eff) of my portfolio. Refer to the questions on derivatives. For immunization, Mac. Duration is what they refer to when they say that investment horizon should be equal to the Mac. Duration of the assets i-e. the cash flow from assets are available when liabilities are due.
Thanks abacus, I wish I understood Maccaulay duration better. I’m not sure I completely understand it. Sorry guys, just so I can put this one to rest; Are we saying the “short” duration here is the time to maturity for the Bullet portfolio? i.e. one year to go till the horizon date? or are we saying that we are refering to all points “prior” to the horizon date? I’m completely out to lunch here…I’ve read it, but for some reason, it’s not making sense?
Thanks guys! It finally clicked!!! hopefully I didn’t frustrate any of you… had a wicked mental block! btw-if someone could confirm; if short term interest rates are rising and long term interest rates are falling… Would we prefer a bullet or a barbell? Barbell right? if our forecast is correct, this would result in higher reinvestment of income and bond price valuations ideally we would like to heavily weigh ourselves into long term assets. set ourselves up at the long term end of the yield curve. also, its safe to say, whenever there is unceratainty regarding interest rates, that the Bullet is superior! because of the smaller dispersion of assets around the horizon date.