Question

Jennifer is the portfolio manager of a bond fund is considering the acquisition of an extremely complex bond issue. It is complex because it has multiple embedded options. Jennifer wants to estimate the interest rate risk of the bond issue so that she can determine the impact     of including it in her current portfolio. She contacts the dealer who created the bond issue to obtain an estimate for the issue’s duration. The dealer estimates the duration to be 7. The portfolio manager solicited her firm’s in-house quantitative analyst and asked him to estimate the issue’s duration. He estimates the duration to be 10. Provide an explanation as to why there is such a large difference in the issue’s duration as estimated by the dealer’s analysts and the firm’s in-house analyst?

Answer 1

The duration estimates the interest rate risk of the bond.

As the bond has multiple embedded options, possibly several assumptions, judgements and estimates are required to estimate the duration.

The dealer who created the bond has an interest in selling the bond. Hence, they are likely to use assumptions which are conservative, and thus may understate the interest rate risk of the bond.

On the other hand, the firm’s in-house analyst has an interest in managing the risk of the firm. They are likely to use assumptions which are conservative from the firm's perspective, and thus may overstate the interest rate risk of the bond.