Chapter%209%20Duration%20Illustrative

Chapter%209%20Duration%20Illustrative - In general the...

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FIN 4620 Duration Illustrative You are considering buying one of two bonds. You are choosing between a 7% coupon bond and a 14% coupon bond. Both pay annual coupons, have seven year maturities, offer 8% yields, and have a face value of $100,000. Which bond should you buy IF YOU THINK INTEREST RATES ARE GOING TO GO UP? 5.61 Years 4.99 Years Duration is the weighted-average time to maturity on the loan using the relative present values of the cash flows as weights. It is the point at the present value of the cash flows is evenly distributed. What does Duration tell you about risk? The lower the Duration, the lower the interest sensitivity and, therefore, the lower the risk.
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Unformatted text preview: In general, the lower the coupon payment, the higher the Duration. Why? Because, there is more dependence on the repayment of the face value at maturity than the periodic interest paid to get the required rate of return. As yields increase, Duration decreases (moves to the left). Why? The higher the yield, the more that is earned on reinvested interest and it takes less time to recoup the investment. Conversely, Duration increases when bond yields decrease, since lower yields put greater weights on later payments. Since the 14% bond has a lower Duration, you should buy it if interest rates are expected to increase....
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