Explain the concept of duration and describe how it is used in hedging interest rate futures. Be sure to discuss the limitations of duration.
Duration measures the sensitivity of bond's price to interest rate changes. It is calculated by taking the weighted average of the Present values of cash flows.
Longer the duration of a bond, more is its sensitivity to interest rate changes. Thus, a portfolio of bonds, having a longer duration is more sensitive to interest rate changes than that of a portfolio having shorter duration.
Thus, interest rate futures can be used to hedge the risk of the bond portfolio. An interest rate future based on a lesser duration portfolio can be used to hedge a portfolio of longer duration and vice versa.
Though Duration is a very good measure of the price sensitivity to interest rate changes, but it has some limitations.
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