Investment theory- The concept of Duration Essay

Investment theory- The concept of Duration - Essay Example However, those with good mathematical understanding are made to understand the concepts behind bond duration through some proven mathematical formula, and this imply the correlation between changes in the bond values and the fluctuations in the interest rates. There are two basic applications of the duration principles and these greatly vary with the kind of risk involved as well as the investment strategy put in place. Duration could be used as a measure of bond values persistent investors or those willing to take deadly business risks. Such investors are known to embrace active business strategies and benefit from the anticipated alterations or fluctuations in the interest rates due to changes in the bond durations. However, for non risk takers, duration act as a tool of protecting bond values from certain fluctuations due to fluctuations in the interest rates. Bond protection in this case is kind of a assurance that the bond value is likely to remain stable irrespective of changes in the prevailing interest rates, hence it encourage investors to buy certain bonds as they are not scared of changes in interest rates. Majority of financial analysts assumes that the graph of bond prices verses interest rates is flat, meaning there is major effects of fluctuations in the interest rates on bond prices, and this is not correct as various mathematical formulas can be employed to certify this. ... This method applies the basic mechanical principles to verify the relationship between duration and changes or fluctuations in bond prices. Various sketches of a flagpole could be used to give different visuals to represent the differences in bond durations, which is also associated to the changes in center of gravity of various physical objects (flagpoles). Each object has a single center of gravity, and the same principle is applied to explain the single accumulation of bonds’ value after certain duration. Stable objects tend to have a lower center of gravity and the same applies to stable bonds or rather those with stable values which tend to have a shorter duration. This concept could also be explained using Macaulay duration formulae which is weighted average of maturity bond , attained from this formula = [?tCFt/(1+k)t]/ ?CFt/(1+k)t , where D is the Macaulay duration, t is time period in months or years, n is the maturity periods, K is the prevailing market interest rate s, CF is the cash flow. The formula is an indication that bond duration is subject of four basic factors namely; bond maturity (n), coupon size (C), value of each bond (M) and the prevailing interest rates in the market (k). However, changes in M are usually not included in the analysis in major occasions. The above formula would work well with students with different majors in mathematics or those with deep mathematical understanding. For students with poor mathematical understanding, the concepts of bond durations could be demonstrated using various images of flagpoles. Bond maturity could be represented with the length of the flagpole; the flagpole diameter represents the annual coupon