For a corporate bond that has a low credit rating, why might an analytical duration be limited as a measure of interest-rate risk?

Question

What will be an ideal response?

Answer 1

To understand why an analytical duration is limiting as a measure of interest-rate risk, one must note that the risk associated with a bond is comprised oftwo elements referred to as an equity risk and an interest-rate risk. The purpose of calculating duration is to estimate a bond's interest-rate risk and not its equity risk. Thus, it becomes obvious that duration may prove inadequate. This is especially true when the equity risk component is important as is the case for a corporate bond that has low credit rating indicating volatility similar stock. Thus, for a non-investment-grade or high-yieldcorporate bond, there is a low credit rating and equity risk dominates interest-rate risk.Incontrast, for an investment-grade corporate bond,there is a highcredit rating and so the equity risk component is minor compared to the interest-rate risk. In conclusion, the durationmeasure as calculated by formula may not be a good measure of interest-rate risk forsuch bonds.

To handle equity risk, the estimation of duration of corporate bonds can useregression analysis. Duration calculatedbased on historical data using regression analysis is called empirical duration. To distinguishempirical duration from the calculation of duration using the formula presented inthis chapter, we refer to the formula-driven value as analytical duration.