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Subject 9. Empirical Duration PDF Download

The purpose of calculating duration is to estimate a bond's interest-rate risk. However, a more general way to think about the risk associated with a bond is that it is comprised of two elements: an equity risk and an interest-rate risk. For corporate bonds that have a high credit rating (i.e., investment-grade bonds), the interest-rate risk is the dominant risk. In contrast, for corporate bonds with a low credit rating (i.e., non-investment-grade or high-yield corporate bonds), the equity risk is more likely to be dominant. Hence, the duration measure as calculated by formula (analytical duration) may not be a good measure of interest-rate risk for such bonds.

Empirical duration is the calculation of a bond's duration based on historical data rather than a preset formula, like effective duration does. Simply put, empirical duration is more practical in that it uses historical data to model a bond price's sensitivity to different interest rate scenarios. When the historical yields rise or fall, the historical bond prices will fall or rise accordingly, and this data forms the basis for empirical duration.

The advantages of empirical duration include that the estimate does not rely on theoretical formulas and analytic assumptions; the investor only needs a reliable series of bond prices and a reliable series of Treasury yields. It is a better measure especially under stressed market conditions, for a portfolio consisting of a variety of different bonds from different issuers.

Disadvantages include that a reliable series of a bond's price may not be available, and the series of prices that is available might not be market based, but rather modelled or matrix priced (the price is based on similar security).

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