What are the limitations of using duration as a measure of a bond's price sensitivity to interest-rate changes?
What will be an ideal response?
Below we discuss three limitations of using duration.
First, duration measures are only approximations for small changes in yield. They do not capture the effect of the convexity of a bond on its price performance when yields change by more than a small amount. To get improved accuracy, the duration measure should be supplemented with an additional measure to capture the curvature or convexity of a bond. It is important to note that investors can be misled if they rely on duration as the sole measure of the price volatility of a bond.
Second, in the derivation of the relationship between modified duration and bond price volatility, we started with the bond price equation. This starting point assumes that all cash flows for the bond are discounted at the same discount rate. In essence we are assuming that the yield curve is flat and all shifts are parallel. This assumption does not always hold. This is very important when we try to use a portfolio's duration to quantify the responsiveness of a portfolio's value to a change in interest rates. If a portfolio has bonds with different maturities, the duration measure may not provide a good estimate for unequal changes in interest rates of different maturities.
Third, we must be careful when applying our duration equations to bonds that are not option-free bonds. When changes in yields result in a change in the expected cash flow for a bond, which is the case for bonds with embedded options, the duration and convexity measures are appropriate only in certain circumstances.
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