Windjam

Let us go back to the basics. Duration is the sensitivity of a bond to a change in interest rates, right? If you go along the yield curve the sensitivities of each maturity is different from the next one. I assume we are together up to this point.

If you have a liability of a certain point along the yield curve and you need to match it with an asset, what will you do? I believe the best way to do it is to create an asset that will have the same sensitivity to interest rates (read: the same duration) with the liability. By doing this, you are free from the vagaries of interest rate movements.

Most liabilities are a one time cash outflow but it is difficult to get zero coupon bonds to match the cash flow. The next best thing to do is that get a family of bonds and adjust the duration to match the liability.



Edited 1 time(s). Last edit at Sunday, February 20, 2011 at 02:44PM by me.tega.