DURATION DUE IN WEEK 4

1. The duration equation suggests that duration measures the weighted a erage time !or in estors to re"o er the "ost o! their #ond in estment !rom the "ash !$ows o! the #ond. %ow do &ou arri e at the equation' What is the rationa$e o! the (ro"ess' The weighted average time for investors to recover the cost of their bond investment from the cash flows of the bond implies the following: MacDur = w1t1 + w2t2 + ... + wt 1tt 1 + wt tt = n =1 wntn
t

The weights, w1 , w2 and wt 1 represent the proportion of initial cost recovered from the present value of the 1st, 2nd, and second last coupon interest: CPP 1 i.e. w1 =

( 1+ r )
P0

CPP2 , w2 =

(1+ r )
P0

CPPt 1 , w1 =

( 1+ r )
P0

t 1

wt represents the proportion of initial cost recovered from the present value of the last coupon interest and face value:

( CPPt + FV )
i.e. wt = P0

( 1+ r )

t1 , t2 and tt 1 corresponds to the time when the 1st, 2nd, and second last coupon interest is received, and tn corresponds to the time when the last coupon interest and face value is received.

)i( *+,,-. /ession -0 D1 2 to 3. D1 2

D1 4 D1 D

D1 E D1 5 This investment is risk-free, since you are aware of the cost and terminal value of the investment. D1 3 Assumption 1: