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Default risk and the effective duration of bonds

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  • Babbel, David F.
  • Merrill, Craig
  • Panning, William

Abstract

Basis risk is the risk attributable to uncertain movements in the spread between yields associated with a particular financial instrument or class of instruments, and a reference interest rate over time. There are seven types of basis risk: Yields on 1) Long-term versus short-term financial instruments, 2) Domestic currency versus foreign currencies, 3) Liquid versus illiquid investments, 4) Bonds with higher or lower sensitivity to changes in interest rate volatility, 5) Taxable versus tax-free instruments, 6) Spot versus futures contracts and 7) Default-free versus non-default-free securities. Basis risk makes it difficult for the fixed-income portfolio manager to measure the portfolio's exposure to interest rate risk, heightens the anxiety of traders and arbitrageurs who are hedging their investments, and compounds the financial institution's problem of matching assets and liabilities. Much attention has been paid to the first type of basis risk. In recent years, attention has turned toward understanding the relation between credit risk and duration. The authors focus on that, emphasizing the importance of taking credit risk into account when computing measures of duration. The consensus of all work in this area is that credit risk shortens the effective duration of corporate bonds. The authors estimate how much durations shorten because of credit risk, basing their estimates on observable data and easily estimated bond pricing parameters.

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File URL: http://www-wds.worldbank.org/servlet/WDSContentServer/WDSP/IB/1995/09/01/000009265_3961019143723/Rendered/PDF/multi_page.pdf
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Bibliographic Info

Paper provided by The World Bank in its series Policy Research Working Paper Series with number 1511.

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Date of creation: 30 Sep 1995
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Handle: RePEc:wbk:wbrwps:1511

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Related research

Keywords: Banks&Banking Reform; Payment Systems&Infrastructure; International Terrorism&Counterterrorism; Economic Theory&Research; Insurance&Risk Mitigation; Environmental Economics&Policies; Strategic Debt Management; Economic Theory&Research; Banks&Banking Reform; Insurance&Risk Mitigation;

References

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  1. Jarrow, Robert A & Turnbull, Stuart M, 1995. " Pricing Derivatives on Financial Securities Subject to Credit Risk," Journal of Finance, American Finance Association, vol. 50(1), pages 53-85, March.
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Cited by:
  1. David F. Babbel & Craig B. Merrill & Mark F. Meyer & Meiring de Villiers, 2001. "The Effect of Transaction Size on Off-the-Run Treasury Prices," Center for Financial Institutions Working Papers, Wharton School Center for Financial Institutions, University of Pennsylvania 01-03, Wharton School Center for Financial Institutions, University of Pennsylvania.
  2. David F. Babbel & Anthony M. Santomero, 1997. "Risk Management by Insurers: An Analysis of the Process," Center for Financial Institutions Working Papers, Wharton School Center for Financial Institutions, University of Pennsylvania 96-16, Wharton School Center for Financial Institutions, University of Pennsylvania.
  3. Sarkar, Sudipto & Hong, Gwangheon, 2004. "Effective duration of callable corporate bonds: Theory and evidence," Journal of Banking & Finance, Elsevier, vol. 28(3), pages 499-521, March.
  4. Scott D. Aguais & Anthony M. Santomero, 1997. "Incorporating New Fixed Income Approaches into Commercial Loan Valuation," Center for Financial Institutions Working Papers, Wharton School Center for Financial Institutions, University of Pennsylvania 98-06, Wharton School Center for Financial Institutions, University of Pennsylvania.
  5. Kraft, Holger & Munk, Claus, 2007. "Bond durations: Corporates vs. Treasuries," Journal of Banking & Finance, Elsevier, vol. 31(12), pages 3720-3741, December.
  6. Jacoby, Gady & Roberts, Gordon S., 2003. "Default- and call-adjusted duration for corporate bonds," Journal of Banking & Finance, Elsevier, vol. 27(12), pages 2297-2321, December.

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