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    Chapter 8 (P. 183-188) Estimation Errors From Using Modified Duration

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    Cheese Butter
    Modified duration is an estimate of how much a bond's price will change given a change in interest rates, but it tends to overestimate price declines from rate increases and underestimate price increases from rate decreases. A more accurate estimate incorporates bond convexity as well as duration. Bond investors employ strategies like matching income needs, laddering across maturities, concentrating on short and long maturities, and making interest rate forecasts to manage their bond portfolios. International bonds are subject to foreign interest rate movements, credit risk, and exchange rate fluctuations, so diversifying across countries can help reduce exposure to these risks.

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    Chapter 8 (P. 183-188) Estimation Errors From Using Modified Duration

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    Cheese Butter
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    Modified duration is an estimate of how much a bond's price will change given a change in interest rates, but it tends to overestimate price declines from rate increases and underestimate price increases from rate decreases. A more accurate estimate incorporates bond convexity as well as duration. Bond investors employ strategies like matching income needs, laddering across maturities, concentrating on short and long maturities, and making interest rate forecasts to manage their bond portfolios. International bonds are subject to foreign interest rate movements, credit risk, and exchange rate fluctuations, so diversifying across countries can help reduce exposure to these risks.

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    CHAPTER 8

    Original Title

    Chapter 8

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    Modified duration is an estimate of how much a bond's price will change given a change in interest rates, but it tends to overestimate price declines from rate increases and underestimate price increases from rate decreases. A more accurate estimate incorporates bond convexity as well as duration. Bond investors employ strategies like matching income needs, laddering across maturities, concentrating on short and long maturities, and making interest rate forecasts to manage their bond portfolios. International bonds are subject to foreign interest rate movements, credit risk, and exchange rate fluctuations, so diversifying across countries can help reduce exposure to these risks.

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    © All Rights Reserved
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    26 views3 pages

    Chapter 8 (P. 183-188) Estimation Errors From Using Modified Duration

    Uploaded by

    Cheese Butter
    Modified duration is an estimate of how much a bond's price will change given a change in interest rates, but it tends to overestimate price declines from rate increases and underestimate price increases from rate decreases. A more accurate estimate incorporates bond convexity as well as duration. Bond investors employ strategies like matching income needs, laddering across maturities, concentrating on short and long maturities, and making interest rate forecasts to manage their bond portfolios. International bonds are subject to foreign interest rate movements, credit risk, and exchange rate fluctuations, so diversifying across countries can help reduce exposure to these risks.

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    of 3

    Chapter 8 (p.

    183-188)

    Estimation Errors from Using Modified Duration

    - If investors rely strictly on modified duration to estimate the percentage change in the price of a
    bond, they will tend to overestimate the price decline associated with an increase in rates and
    to underestimate the price increase associated with a decrease in rates.

    Ex.
    Consider a bond with 10 percent coupon that pays interest annually and has 20 years to
    maturity. If the required rate of return is 10 percent (the same as the coupon rate), the value of
    the bond is $1,000. Based on the formula provided earlier, this bond’s modification duration is
    8.514 years. If investors anticipate the bond yields will increase by 1 percentage point (to 11
    percent), they can estimate the percentage change in bond’s price to be

    %∆ Pb = -8.514 x 0.01
    = -0.08514 or 8.514%

    (WAIT LANG TO HAHAHA DI KO PA GETS HUHU)

    Bond Convexity

    - A more complete formula to estimate the percentage change in price in response to a change in
    yield will incorporate the property of convexity as well as modified duration.

    BOND INVESTMENT STRATEGIES

     Matching Strategy

    - Some investors create a bond portfolio that will generate periodic income to match their
    expected periodic expenses.
     Laddered Strategy

    - Funds are evenly allocated to bonds in each of several different maturity classes.

     Barbell Strategy

    - Funds are allocated to bonds with a short term to maturity as well as to bonds with a long term
    to maturity.

     Interest Rate Strategy

    - Funds are allocated in a manner that capitalizes on interest rate forecasts.

    - This strategy requires frequent adjustments in the bond portfolio to reflect the prevailing
    interest rate forecast.

    VALUATION AND RISK OF INTERNATIONAL BONDS

     Influence of Foreign Interest Rate Movements

    - As the risk-free interest rate of a currency changes, the required rate of return by investors in
    that country changes as well. Thus, the present value of a bond denominated in that currency
    changes.

     Influence of Credit Risk

    - As the perceived credit (default) risk of an international bond changes, the risk premium within
    the required rate of return by investors is affected. Consequently, the present value of the bond
    changes.

     Influence of Exchange Rate Fluctuations


    - Change in the value of the foreign currency denominating a bond affect the U.S. dollar cash
    flows generated from the bond and thereby affect the return to U.S. investors who invested in
    it.

     International Bond Diversification

    - When investors attempt to capitalize on investments in foreign bonds that have higher interest
    rates than they can obtain locally, they may diversify their foreign bond holdings among
    countries to reduce their exposure on different types of risk.

     Reduction of Interest Rate Risk

    - Institutional investors diversify their bond portfolios internationally to reduce exposure


    to interest rate risk.

     Reduction of Credit Risk

    - Another key reason for international diversification is the reduction of credit (default)
    risk. Investment in bonds issued by corporations from a single country can expose
    investors to a relatively high degree of credit risk.

     Reduction of Exchange Rate Risk

    - Financial institutions may attempt to reduce their exchange rate risk by diversifying
    among foreign securities denominated in various foreign currencies. In this way, a
    smaller portion of their foreign security will be exposed to the depreciation of any
    particular foreign currency.

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