Even at L3, I still don’t think I have a full handle of the concept of duration. Can you guys run down how you look at this topic? Talk to me like I am in third grade.
1st attempt. Duration is an linear approximation of the change of bond price given change in the level of interest rate.
Haha mwvt9 this is just creepy. I was going to post almost the exact same thing (same wording and everything) a few days ago and then didn’t out of embarassment. Why is duration so confusing?
Duration is a bond’s price sensitivity to changes in interest rates. The higher the duration, the more a bond will react to a movement in i-rates. Longer maturity bonds have greater durations and therefore react more sharply to i-rate changes. Duration is a good measure of price changes for small i-rate changes but loses its predictive ability for large i-rate changes.
So why do some equity portfolios have duration too?
Duration is basically the sensitivity of price of a fixed income security with change in interest rates and its units is years. High duration means high risk to interest rates. Also, there is a negative relation between then change in price and change in interest rates for fixed income security. Duration = -(change in price)/(change in interest rate) now, if you are expecting interest rates to decrease, you want to derive max. profit so you are long for high duration securities and if you expect interest rates to increase you are long short term and short long term. Also, you cana use derivatives like options, futures, fowards and swaps to change duration of securities, you buy futures to increase duration and sell to decrease it. u must have got that, as its mathematical and calculative, so easy to grasp. hope this helps. addition - duration can be for any asset, its basically price sensiticity of an asset to interest rate movements, however, generally it is referred with respect to fixed income securities as they are very sensitive to interest rates.
I get what everybody has said so far. I can’t even put into words exactly what I don’t understand. I know it is the measure of the change in bond price to small changes in IR (need to add second derivative of convexity too). Weighted time to cash flows (loose defintion). I don’t know…I just wanted to here other people explain it to see if something clicked.
gauravku Wrote: ------------------------------------------------------- > Duration is basically the sensitivity of price of > a fixed income security with change in interest > rates and its units is years. High duration means > high risk to interest rates. Also, there is a > negative relation between then change in price and > change in interest rates for fixed income > security. > > Duration = -(change in price)/(change in interest > rate) > > now, if you are expecting interest rates to > decrease, you want to derive max. profit so you > are long for high duration securities and if you > expect interest rates to increase you are long > short term and short long term. Also, you cana use > derivatives like options, futures, fowards and > swaps to change duration of securities, you buy > futures to increase duration and sell to decrease > it. u must have got that, as its mathematical and > calculative, so easy to grasp. > > hope this helps. > > addition - duration can be for any asset, its > basically price sensiticity of an asset to > interest rate movements, however, generally it is > referred with respect to fixed income securities > as they are very sensitive to interest rates. Thanks gauravku.
Eeeek… Can’t be done at the third grade level. But there are really two ways to look at duration very simply. The easy way to look at duration isn’t really technically accurate, but it will certainly help you to hold your own in any discussion of the issue. And that is to think of duration as the weighted average time to receive your principal back on a fixed income security. Thinking about things this way helps you to appreciate some simple relationships – like, for instance, why a high coupon 30 year bond has a SHORTER duration than a low or zero coupon 30 year bond. The high coupon (let’s say it’s 10% / year) will repay your principal in ten years. The weighted average is clearly lower than it would be for a 5% or 0% coupon bond, right? You get your original investment back quicker because of the high coupon payments. You can also easily appreciate another relationship from this simple definition… the higher a price you pay for the bond, the longer the duration. This is kind of obvious because if you pay 105 for a bond (versus, say, a price of 98), then it will take you somewhat longer to get your original investment of 105 back than it would take to get the 98 back, right? So there’s a real basic explanation of duration that just happens to be wrong according to the CFA. Technically, it’s not really wrong, but it is a somewhat limited over-simplification. And it definitely won’t get you through level III. For instance, if you think of duration as time to get paid back, then what meaning is there in the duration of a bond future?
plyon Wrote: ------------------------------------------------------- > For > instance, if you think of duration as time to get > paid back, then what meaning is there in the > duration of a bond future? You just blew my mind.
mwvt9 Wrote: ------------------------------------------------------- > plyon Wrote: > -------------------------------------------------- > ----- > > For > > instance, if you think of duration as time to > get > > paid back, then what meaning is there in the > > duration of a bond future? > > You just blew my mind. Good… now your following. The simple third grade definition falls apart. Which is why we are back to the change in price / change in interest rates. I wouldn’t even try to describe or understand that relationship too much at first. Try not to even focus on the fact that the denominator is “change in interest rates” (as opposed to the change of the price of tea in China). Duration (bad name under our new understanding) is just the sensitivity of the price of one thing in relation to another thing. In this way, you can see that duration is alot like beta. Something with a high (or “long”) duration / beta is going to move much more in price than something with a low duration / beta, given a certain movement in the underlying. Sure… the underlying happens to be an interest rate, but don’t let that throw you off at this point.
plyon, I am going to shoot you an email.
Can you explain duration of cash? In schweser it says low like 0.25 Can someone explain this. How would you think of cash from a weighted average time to receive your principal point of view
I think they are using the term cash here loosely. Like cash could = T-bills.
mwvt9 Wrote: ------------------------------------------------------- > I think they are using the term cash here loosely. > Like cash could = T-bills. Yep… And since the T-bill is basically the same as a zero coupon bond, the duration of a T-bill, or an agency discount note, or a piece of non-interest bearing commercial paper (these are all discount items) would be equivalent to its maturity (something that can be easily deduced under the simply understanding of duration).
Maybe it won’t get me through L3, but I really like your explanation anyway. It’ll help me keep some concepts straight in my mind. Thanks.
Bravo Plyon!
Duation is to delta as convexity is to gamma.
amit_cfa2 Wrote: ------------------------------------------------------- > Can you explain duration of cash? In schweser it > says low like 0.25 > > Can someone explain this. How would you think of > cash from a weighted average time to receive your > principal point of view I think you are missing the point. At this point in your studying you should not be thinking of duration as a weighted time to receive cash flows. It is simply wrong. First of all…duration will almost always be a negative number (in the case of negative convexity there will be a potential for positive duration). We all just quote it as the absolute value for convenience. Therefore, what is the meaning of a duration of -3.5? It sure isn’t negative 3.5 years until the average cash flow is received. I don’t even know what -3.5 years means. Instead, it refers to the inverse relationship between prices and yields, and is only an instantaneous rate of change. That’s it…it’s the derivative of price function with respect to yield, and then divided by the original price.
wyantjs Wrote: ------------------------------------------------------- > amit_cfa2 Wrote: > -------------------------------------------------- > ----- > > Can you explain duration of cash? In schweser > it > > says low like 0.25 > > > > Can someone explain this. How would you think > of > > cash from a weighted average time to receive > your > > principal point of view > > > I think you are missing the point. At this point > in your studying you should not be thinking of > duration as a weighted time to receive cash flows. > It is simply wrong. First of all…duration > will almost always be a negative number (in the > case of negative convexity there will be a > potential for positive duration). We all just > quote it as the absolute value for convenience. > Therefore, what is the meaning of a duration of > -3.5? It sure isn’t negative 3.5 years until the > average cash flow is received. I don’t even know > what -3.5 years means. Instead, it refers to the > inverse relationship between prices and yields, > and is only an instantaneous rate of change. > That’s it…it’s the derivative of price > function with respect to yield, and then divided > by the original price. I wouldn’t discard the second definition of duration because it is quite helpful. It’s good to know that duration of 1 year pure discount note is 1 without having to perform complex calculations. Duration is typically a positive number as duration D is defined as dP(%) = -D*dI(%).