Reading #55 Fixed Income Risk/Return

CFA Level I Fixed Income
#1

Can someone please explain the difference in using effective duration here, instead of ModDur? They have the exact same formula, except that EffectiveDur uses a benchmark in the denominator instead of the change in YTM, correct? Also, I thought Effective duration was used with embedded options, ie. callable bond… If the question stated find ModDur instead of Effective duration, would the answer also have been B? Just trying to wrap my head around the difference here, as this seems to be the most difficult chapter I’ve run across… A noncallable bond with seven years remaining to maturity is trading at 108.1% of a par value of $1,000 and has an 8.5% coupon. If interest rates rise 50 basis points, the bond’s price will fall to 105.3% and if rates fall 50 basis points, the bond’s price will rise to 111.0%. Which of the following is closest to the effective duration of the bond? A) 6.12. B) 5.27. C) 5.54.

The formula for effective duration is: (V- - V+) / (2V0Δcurve). Therefore, effective duration is: ($1.110 - $1.053) / (2 × $1.081 × 0.005) = 5.27.

#2

I wrote an article about this: http://financialexamhelp123.com/macaulay-duration-modified-duration-and-effective-duration/

The short answer is that modified duration assumes that the cash flows won’t change when the YTM changes, whereas effective allows that the cash flows might change when the YTM changes. For bonds for which the cash flows don’t change – fixed coupon, no embedded options – they’re identical. For bonds for which the cash flows might change – floating-rate, or with embedded options – they’re different, and effective duration is a better measure of interest rate risk.

#3

Thanks Magician. Am checking it out and saving the link! We all appreciate your responses on here.

#4

My pleasure.

#5

We have a couple of videos on this reading where we talk about the different duration measures. You may find them helpful:

https://youtu.be/YrwNX_uaGWE

https://youtu.be/Gsq6EA2IFFc

Good luck on the exam!

BullishBear Finance

#6

Thank you sir. I’ve seen your posts and they are always helpful. I’ll take a look and thank you for the well wishes!