What's Wrong with Those Duration Measures? Nothing... and Everything

Abstract

The purpose of this paper is to explain some misunderstood aspects of structuring duration-neutral bond trades. In particular, we demonstrate that the widely held notion that nominal and effective durations for bonds without embedded options are equal is mistaken by a large enough amount to be of consequence in some applications. While the paper emphasizes duration-neutral bond trades, it is also about yield curve shifts. We demonstrate that the relationship between par and spot curves, and their shifts, leads to different nominal and effective durations for bonds without embedded options. Because Bloomberg is one of the most widely used tools in fixed income investments, we will couch a substantial fraction of the discussion in terms of Bloomberg screens. We consider a sample trade that demonstrates how large the difference in position weighting can be when choosing between nominal and effective duration. In addition, we demonstrate that the only consistent measure of duration, one that aggregates correctly, when yield curves are not flat is effective duration.