Hi All,
Not sure if this is required for the exam, I am just wondering why do we need to assume parallel shifts in the yield curve for duration to work? Is this due to duration being a linear estimate??
Thanks!
For a single bond, we don’t have to assume a parallel shift in the (par) yield curve; the only change that matters is the par rate at the maturity of that particular bond.
For a portfolio of bonds with a variety of maturities, we assume a parallel shift in the (par) yield curve so that the modified (or effective) duration of the portfolio is the weighted average of the modified (respectively, effective) durations of the constituent bonds (with the weights being the market values of each bond).
It has nothing to do with modified (or effective) duration being a linear estimate of the percentage price change in a bond.
As an aside, at Level II you’ll learn about key rate durations, whereupon you can abandon the assumption of parallel shifts in the (par) yield curve.
Thanks for clarifying. I couldnt understand the reasoning if it applied to a single bond.