Duration/Convexity Approach Advantage

C

The advantage of the duration/convexity approach over the full valuation approach is:

C. It saves considerable time when working with portfolios of bonds.

Explanation:

The duration/convexity approach is a simplified method used to estimate the price change of a bond or a portfolio of bonds in response to changes in interest rates. It relies on two key measures: duration and convexity.

Duration is a measure of a bond's price sensitivity to changes in interest rates. It represents the weighted average time it takes to receive the bond's cash flows (including both coupon payments and principal) and is typically expressed in years. Duration provides an estimate of the percentage change in the bond's price for a given change in interest rates.

Convexity, on the other hand, is a measure of the curvature of the bond's price-yield relationship. It helps capture the non-linear relationship between changes in interest rates and bond prices. Convexity provides an adjustment to the duration measure and helps improve its accuracy, particularly for larger changes in interest rates.

Now, let's compare the duration/convexity approach to the full valuation approach:

1. Accuracy for nonparallel shifts in the yield curve: The full valuation approach involves calculating the present value of all future cash flows (coupons and principal) using a range of different interest rates along the yield curve. This approach allows for more accurate valuations, especially when there are nonparallel shifts in the yield curve (i.e., when different maturities experience different changes in interest rates).

In contrast, the duration/convexity approach assumes that changes in interest rates are parallel across all maturities. This simplification may lead to less accuracy when there are nonparallel shifts in the yield curve. Therefore, option A is incorrect.

2. Dependency on yield to maturity: The full valuation approach requires the determination of the yield to maturity (YTM) for each bond. YTM is a summary measure that represents the discount rate that equates the present value of a bond's future cash flows to its current market price. The full valuation approach relies on YTM for pricing, and any errors in estimating YTM can affect the accuracy of the valuation.

In contrast, the duration/convexity approach does not explicitly rely on YTM. Instead, it uses duration and convexity to estimate the price change. This makes the approach less dependent on a single summary measure and potentially less sensitive to errors in YTM estimation. Therefore, option B is incorrect.

3. Time-saving when working with portfolios of bonds: The duration/convexity approach is particularly useful when dealing with portfolios of bonds. Instead of valuing each bond individually using the full valuation approach, which can be time-consuming and computationally intensive, the duration/convexity approach allows for quick estimates of price changes for the entire portfolio.

By applying duration and convexity measures to the portfolio as a whole, the duration/convexity approach simplifies the calculation process, saving considerable time. Therefore, option C is correct.

In summary, the advantage of the duration/convexity approach over the full valuation approach is that it saves considerable time when working with portfolios of bonds.