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Hi guys
Can anyone again explain the duration and its purpose? I still don’t get why is it better than disc.payback? I have read Prof Bob Ryan blog thread on this and ACCA books but stil confused.
Thanks
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Firstly, you have to understand how we calculate bond duration (i.e. Macaulay Duration). You may refer to Investopedia’s Example 1 for an illustration. You can see that the duration of the Vanilla Bond at Example 1 is 4.55 years.
If you apply discounted payback to the same Example, the payback period becomes 5 years. Now, I change the Example 1’s Vanilla Bond to one of Zero Coupon Bond. In other words, its cost is $1,000 now and repaid with $1,276.28 ($1,000 compounded in 5 years) at end of Year 5. If you apply the Duration formula to the Zero Coupon Bond, its duration becomes 5 years. It perfectly matches the result of discounted payback.
In other words, discounted payback wrongly assumes that the coupon will be kept for reinvestment at the required yield for the Vanilla Bond. The usefulness of using discounted payback to measure volatility is limited, applicable to Zero Coupon Bond only.
I would not repeat the reason for calculating duration here because Investopedia has already explained well.
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