Duration slides

Why does duration give us a measure of elasticity?

Peter Fraser

(c) P Fraser 2010 1

Forget weighted averages?
 Duration originally conceived as
alternative to maturity.

C 2C NC N
2
... n n
1 r 1 r 1 r 1 r
D
P
 More importantly used as sensitivity of
price changes to interest rates.
 Basic relationship: dP
MD * P
dr
(c) P Fraser 2010 2
 Why? (mathematical interlude)
 Price of a bond is discounted sum of cash
flows

C C C C 1
P 2 3
... n n
1 r 1 r 1 r 1 r 1 r

 Differentiate to discover sensitivity to

rates
dP
dr

(c) P Fraser 2010 3

 Why? (cont…)
 Use product and chain rule for each
term.
dP C 2C NC N
2 3
... n 1 n 1
dr 1 r 1 r 1 r 1 r

 multiply both sides by 1 r

dP C 2C NC N
1 r 2
... n n
dr 1 r 1 r 1 r 1 r
(c) P Fraser 2010 4
Why? (cont…)
Right-hand side divided by price =
- duration. Divide both sides by price
dP
1 r
dr D
P
dP
1 r D*P
dr
dP D
*P
dr 1 r =-MD!
(c) P Fraser 2010 5