Duration Model and Problems Associated with it

The Duration Model is based on market value and helps to manage interest rate risk. The market value approach helps to identify the true value of assets and liabilities. For example, if a bond was purchased at a 4% R sometime back, and if the R has fallen to 3% at present, the bond must be stated at the new price which is higher. 

Duration helps to manage the interest rate risk by measuring the interest rate sensitivity of an asset or liability; it also measures the percentage fall in bond’s price with a corresponding increase in interest rate. Duration model helps to protect individual instruments and assess the overall exposure of assets and liabilities of an FI to R.  

Duration Model and Problems Associated with it

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However, duration model has certain problems. They are as follows:

• Duration model is considered to be costly to hedging positions.
• It estimates the interest rate changes based on the market value; but certain margin of error is resulted due to this.
• Assets and liabilities have to be regularly re-structured.
• Duration model is ideal for only small increase in R.
• It considers the expenses associated with immunization policies.
• Convexity problems will occur.