Chapter 13 DURATION ANALYSIS AND ITS APPLICATIONS. Abstract We discuss duration and its development, placing particular emphasis on various applications. The survey begins by introducing duration and showing how traders and portfolio managers use this measure in speculative and hedging strategies. | Chapter 13 DURATION ANALYSIS AND ITS APPLICATIONS IRAJ J. FOOLADI Dalhousie University Canada GADY JACOBY University of Manitoba Canada GORDON S. ROBERTS York University Canada Abstract We discuss duration and its development placing particular emphasis on various applications. The survey begins by introducing duration and showing how traders and portfolio managers use this measure in speculative and hedging strategies. We then turn to convexity a complication arising from relaxing the linearity assumption in duration. Next we present immunization - a hedging strategy based on duration. The article goes on to examine stochastic process risk and duration extensions which address it. We then examine the track record of duration and how the measure applies to financial futures. The discussion then turns to macrohedging the entire balance sheet of a financial institution. We develop a theoretical framework for duration gaps and apply it in turn to banks life insurance companies and defined benefit pension plans. Keywords duration fixed-income securities immunization hedging interest rate risk macrohedging bond price volatility stochastic process risk financial institution management pension funds insurance companies banks . Introduction Duration Analysis is the key to understanding the returns on fixed-income securities. Duration is also central to measuring risk exposures in fixed-income positions. The concept of duration was first developed by Macaulay 1938 . Thereafter it was occasionally used in some applications by economists Hicks 1939 Samuelson 1945 and actuaries Redington 1952 . However by and large this concept remained dormant until 1971 when Fisher and Weil illustrated that duration could be used to design a bond portfolio that is immunized against interest rate risk. Today duration is widely used in financial markets. We discuss duration and its development placing particular emphasis on various applications. The survey begins by introducing duration .
