Yield curve risk - quick question

CFA Level III
#1

Hi Brave Ones,

Can someone please explain why the following statement is not correct?

“Yield curve risk for securities with bullet maturities can’t be accurately measured by effective duration”

many thanks and keep commitment high.

#2

Effective duration measures parallel shifts in the yield curve–not twists.

Yield curve risk is the risk of twists in the yield curve.

So effective duration is not an accurate measure of yield curve risk.

Also, keep in mind that for bullet maturities, a significant portion of the cash flow is received at maturity, so yield curve risk is less of a factor than for MBS, which are amortizing securities.

#3

many thanks.

#4

I thought the OP asked to prove the statement wrong – but it was proved right

Did i misunderstand?

#5

we should use key rate duration instead, that’s my understanding.

#6

Doesn’t work because bullet maturity still has coupons. Only zeros can have ED used for YCR.

#7

I thought bullet maturity meant no intervening cash flows prior to maturity. How can it have coupons then?

#8

This is not a very high quality question in my opinion, but the point is that since bullet bonds receive a significant portion of their cash flow at maturity, yield curve risk is minimal to none (since the cash flows at each payment date are so small). So the changes in yield corresponding to the maturity of the bond is mostly what matters (and this is what duration looks at).

So effective duration CAN measure it accurately only because yield curve risk is so small and the only significant cash flow is the one at maturity.

For example, a $100M, 30 year bond that pays 3% annually will have small coupon payments each year and then a huge $100M + coupon payment at maturity. So relative to the single cash flow at maturity, these intermittment coupon cash flows are insignificant.

However, for an MBS, which amortizes with P and I payments each period, the YC Risk is much greater.

This is laid out in Schweser Book 3 Page 116.

#9

you’re thinking of a zero coupond bond

zero coupon bond: no cash flow till maturity

bullet bond: onlyinterest payments till maturity, then interest + principal at maturity

MBS: interest + principal every period