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Questions and Answers
What is Macaulay duration?
What is Macaulay duration?
A measure of the weighted average time until a bond’s cash flows are received, expressed in years.
What does modified duration estimate?
What does modified duration estimate?
The percentage change in a bond’s price given a 1% change in interest rates.
What does convexity measure?
What does convexity measure?
The curvature or non-linear relationship between bond prices and changes in interest rates.
Which of the following is a characteristic of the primary capital market?
Which of the following is a characteristic of the primary capital market?
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What distinguishes the secondary capital market?
What distinguishes the secondary capital market?
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Which of the following statements is true about Macaulay duration and modified duration?
Which of the following statements is true about Macaulay duration and modified duration?
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How do weather derivatives function?
How do weather derivatives function?
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Macaulay duration is primarily used as a practical measure of interest rate risk.
Macaulay duration is primarily used as a practical measure of interest rate risk.
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Study Notes
Macaulay Duration
- Measures the weighted average time until bond cash flows are received.
- Expressed in years.
- Indicates the time for an investor to recover the bond's price.
- Gauges the bond's sensitivity to interest rate changes.
Modified Duration
- Adjusts Macaulay duration to estimate the percentage change in a bond's price given a 1% change in interest rates.
- A practical measure of interest rate risk.
- Shows how sensitive a bond's price is to interest rate fluctuations.
Convexity
- Measures the curvature or non-linear relationship between bond prices and changes in interest rates.
- Accounts for changes in a bond's duration as interest rates change.
- Bonds with higher convexity are less affected by interest rate volatility, providing more accurate duration estimates for larger rate changes.
Primary Capital Market
- Market where new securities (stocks, bonds) are issued and sold to investors.
- Issuers raise new capital.
- Transactions result in a capital inflow for the issuer.
Secondary Capital Market
- Market where existing securities are traded between investors.
- Provides liquidity and marketability.
- Transactions do not directly affect the issuer’s capital.
- Examples include stock exchanges and over-the-counter (OTC) markets.
Macaulay vs. Modified Duration
- Macaulay Duration: Expressed in years, reflects the weighted average time until bond cash flows are received, primarily a theoretical measure.
- Modified Duration: Adjusted from Macaulay duration to reflect price sensitivity, estimates the percentage price change of a bond in response to a 1% change in interest rates, making it more practical for assessing interest rate risk.
How Weather Derivatives Work
- Financial instruments used to hedge against or speculate on weather-related risks.
- Impacts sectors like agriculture and energy.
- Buyer of a weather derivative sets terms based on a weather index (e.g., CDDs, HDDs, or precipitation levels) for a specific period.
- If the weather outcome differs from the index by a predetermined margin, the seller compensates the buyer.
- They provide a flexible way to manage weather exposure in climates with variable conditions.
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Description
This quiz covers essential concepts related to bond duration, including Macaulay Duration, Modified Duration, and Convexity. It also explores the Primary Capital Market where securities are issued. Test your understanding of how these factors affect bond pricing and interest rate sensitivity.
