Question

Explain the concept of duration and describe how it is used in hedging interest rate futures.    Be sure to discuss the limitations of duration.

Answer 1

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.

• The relationship between price and interest rate is non-linear.
• Duration changes with the passage of time.