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Reading 67: Introduction to the Measurement of Interest Rate

Session 16: Fixed Income: Analysis and Valuation
Reading 67: Introduction to the Measurement of Interest Rate Risk

LOS g: Calculate the duration of a portfolio, given the duration of the bonds comprising the portfolio, and explain the limitations of portfolio duration.

 

 

A bond portfolio consists of a AAA bond, a AA bond, and an A bond. The prices of the bonds are $1,050, $1,000, and $950 respectively. The durations are 8, 6, and 4 respectively. What is the duration of the portfolio?

A)
6.07.
B)
6.00.
C)
6.67.


 

The duration of a bond portfolio is the weighted average of the durations of the bonds in the portfolio. The weights are the value of each bond divided by the value of the portfolio:

portfolio duration = 8 × (1050 / 3000) + 6 × (1000 / 3000) + 4 × (950 / 3000) = 2.8 + 2 + 1.27 = 6.07.

Suppose you have a three-security portfolio containing bonds A, B and C. The effective portfolio duration is 5.9. The market values of bonds A, B and C are $60, $25 and $80, respectively. The durations of bonds A and C are 4.2 and 6.2, respectively. Which of the following amounts is closest to the duration of bond B?

A)
7.4.
B)
9.0.
C)
1.4.


Plug all the known figures and then solve for the one unknown figure, the duration of bond B. 

Proof: (60/165 × 4.2) + (25/165 × 9.0) + (80/165 × 6.2) = 5.9

TOP

Which of the following statements about portfolio duration is NOT correct? It is:

A)
a measure of interest rate risk.
B)
a simple average of the duration estimates of the securities in the portfolio.
C)
the weighted average of the duration estimates of the securities in the portfolio.


Portfolio duration uses a weighted average figure, not a simple average.


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Suppose you have a two-security portfolio containing bonds A and B. The book value of bond A is $20 and the market value is $35. The book value of bond B is $40 and the market value is $50. The duration of bond A is 4.7 and the duration of bond B is 5.9. Which of the following amounts is closest to the duration of the portfolio?

A)
5.4.
B)
5.5.
C)
5.3.


Market values (not book values) should be used to calculate effective portfolio duration. >>

(35/85 × 4.7) + (50/85 × 5.9) = 5.41

TOP

Vijay Ranjin, CFA, is a portfolio manager with Golson Investment Group. He manages a fixed-coupon bond portfolio with a face value of $120.75 million and a current market value of $116.46 million. Golson’s economics department has forecast that interest rates are going to change by 50 basis points. Based on this forecast, Ranjin estimates that the portfolio’s value will increase by $2.12 million if interest rates fall and will decrease by $2.07 million if interest rates rise. Which of the following choices is closest to the portfolio’s effective duration?

A)
3.6.
B)
4.3.
C)
0.4.


Effective duration = (price when interest rates fall ? price when interest rates rise) / (2 × initial price × basis point change)

= (118.58 – 114.39) / (2 × 116.46 × 0.005) = 3.60.

TOP

Which of the following is the most significant limitation of the portfolio duration measure? The assumption of:

A)
a nonparallel shift in the yield curve.
B)
a linear approximation of the actual price-yield function.
C)
a parallel shift in the yield curve.


The most significant limitation of portfolio duration is the assumption that the yield for all maturities changes by the same amount (a parallel shift in the yield curve).

TOP

Which of the following is NOT a limitation of the portfolio duration measure?

A)
It assumes that the yield for all maturities changes by the same amount.
B)
It is subject to huge swings in value since market values may change over time.
C)
It is subject to huge swings in value since book values may change over time.


Bond duration is calculated using market values; changes in book values are irrelevant

TOP

Which of the following is a limitation of the portfolio duration measure? Portfolio duration only considers:

A)
the market values of the bonds.
B)
a nonparallel shift in the yield curve.
C)
a linear approximation of the actual price-yield function for the portfolio.


Duration is a linear approximation of a nonlinear function. The use of market values has no direct effect on the inherent limitation of the portfolio duration measure. Duration assumes a parallel shift in the yield curve, and this is an additional limitation.

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