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Fixed Income Class Notes Chapter 6

Fixed Income Class Notes Chapter 6 - principal Barbell vs...

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Fixed Income Class Notes Chapter 6 – 11/3/11 Measures of price sensitivity have two important weaknesses. They can be used reliably only on fixed cash flows and the assumption of parallel yield shifts is not reliable and is inconsistent. BUT, they are easy to use, can be used to support intuition and validated with better measure of sensitivity. Modified duration equals the time-weighted present value of the cash flows divided by price, times one plus half the yield. (6.13, 6.14) Macaulay duration equals the time-weighted present value of cash flows divided by price. It is not used very often today. (6.16). Perpetuities – a derivation of perpetuity values assumes that the principal is never repaid. There is no difference in value between a bond that pays only coupons forever and a bond that pays coupons forever and then pays
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Unformatted text preview: principal. Barbell vs. the bullet. Barbelling refers to the use of a portfolio of short and long term bonds rather than intermediate maturity bonds. An asset liability manager might have liabilities each with duration equal to n a certain maturity and so the portfolio duration is equal to that maturity. Proceeds gained from incurring those liabilities could be used to purchase several assets with a duration equal to the liability portfolio, or to purchase very short or very long securities that average out top the liability duration. The former of these instances would represent a bullet portfolio and the latter would be a barbell portfolio. A barbell has greater convexity than a bullet because duration increases linearly with maturity while convexity increases with the square of maturity....
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