Chapter 15. Duration Estimation for Bonds and Bond Portfolios

FRANK J. FABOZZI, PHD, CFA, CPA

Professor in the Practice of Finance, Yale School of Management

Abstract: The major risk faced by participants in the bond market is interest rate risk. An investor or a portfolio manager can measure the exposure to interest rate changes of a position by revaluing that position based on various interest rate scenarios. However, the typical way in which interest rate risk is measured is by approximating the impact of a change in interest rates on a bond or a bond portfolio. The first approximation is referred to as duration. To improve upon this approximation, a second measure is estimated and is referred to as convexity. There are different types of duration measures: duration, dollar duration, modified duration, Macaulay duration, effective duration, option-adjusted duration, portfolio duration, contribution to portfolio duration, spread duration, and index duration. The duration estimate require a good valuation model.

Keywords: duration, dollar duration, price value of a basis point, dollar value of a basis point, modified duration, Macaulay duration, effective duration, positive convexity, negative convexity, option-adjusted duration, portfolio duration, contribution to portfolio duration, spread duration, index duration

The two characteristics of a bond that affect its interest rate risk are well known: coupon rate and maturity. Specifically, for a given change in interest rates: (1) the ...

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