Question

what are the pros and cons of the Duration Model in Interest rate risk

Answer 1

Duration model uses weighted average time to maturity and the relative present values of cash flows serves as weights. Duration can be defined as a measure of interest rate sensitivity or elasticity of an asset or a liability.

Pros: First and foremost the duration model effectively combines the effects of differences in coupon rates (with regards to a bond) and differences that exist with regards to maturity. Secondly the model is realistic and practical as it is based on the elasticity of bond price with respect to interest rate. Thirdly duration can be combined with hedge positions to immunize balance sheet.

Cons: The duration model is not able to capture large interest rate change effects on an accurate basis. Duration model is useful only in case of small interest rate changes. Secondly duration relationship is affected by call and/or prepayment provisions.