Can anyone advise me what is the definition of “Duration” found in this reading and other readings of level 3 ? Is it “Macaulay Duration”, “Modified Duration” or “Effective Duration” ? We know that “Duration” means “Interest sensitity” in leve 1/2 and in another some readings of level 3, but it seems that “Duration” means “A period of time” in Reading 29 which is inconsistent with the saying in leve 1/2 and in other readings of level 3. There is not any statement explaining in Reading 29 why “Duration” can mean “A period of time” ! Very regrefully, it seems the author did not read the “Fixed Income” portion of level 1/2 curriculum.
I think we really only have two types of duration based calculations: 1. Dollar duration for calculating hedging strategies 2. Break even analysis for sensitivity analysis I believe that DD is based off of moded duration and BEA is based off of effective duration. If I recall, the difference between mod and eff duration is related to assumptions regarding the impact of bond cash flows from rate changes. I think ED incorporates changes in cash flows while MD holds them steady.
AMC, “duration” when used as a measure for interest rate sensitivity, it is still measured in time units. Even how it was used in L1/2. I did not check R29 now, but “duration” is the cash-weighted time-until-payment of all cashflows. Eg. A bond that pays 50k in 2 years and 50k in 4 years has a duration of 3 (years). A zero bond that pays 100k in 5 years has a duration of 5. What this has to do with interest rate sensitivity: The later the payments are received (i.e. the higher the “duration”), the more sensitive these payments are to the interest rate, as the difference in yields between the reference risk free rate and the bond’s yield increases or decreases if there is more time for interest to accrue. Hope this helps.
Maybe look at these threads http://www.analystforum.com/phorums/read.php?13,926907,927934#msg-927934 http://www.analystforum.com/phorums/read.php?13,942460
old_akakaraka, Thank you for your input. As far as I know: “Macaulay Duration” is really some kind of weight-averaged “time period” which may be in unit of years. “Modified Duration” is the first derivative (“Calculus” term) of the price-yield curve of a bond, so it is not a “time period”, ie. it does have any unit. “Effective Duration” is a short-cut to calculate the “Modified Duration” which shall be applicable to “option-embeded bond”, thus, “Effective Duration” is not a “time period” either and it does have any unit either. recycler, Based on above, only “Macaulay Duration” is applicable when the duration is in a unit of “year(s)”. But the magnitude of “Macaulay Duration” shall be different from that of “Modified Duration” and “Effective Duration”. Therefore, I am much confused ! Anybody else can explain ?
From Schweser L1: Macaulay duration is an estimate of a bond’s interest rate sensitivity based on the time, in years, until promised cash flows will arrive. (…) Macaulay duration is the earliest measure of duration, and because it was based on the time, duration is often stated as years. (…)
old_akakaraka, Which duration (Macaulay/Modified/Effectiven) shall be applied when the duration is referred to a “time period” ? Actually the magnitude of these three measures are different for the same one bond. On the other hand, is the duration of a liability is just the time period of the liability ?