The Hidden Connection of Duration to Average Life and Financial Crisis

Abstract

Modified duration and average life are financial measures belonging to the mathematics of discounting. They are frequently confused, even by financial experts. The likely source of confusion is the failure of quantitative credit studies to have developed in tandem with market risk studies. Instead, mathematical ideas have been imported wholesale from trading and used in credit engineering without sensitivity to their different risk polymorphisms. But while market risk is short-term, credit is a long game where the key determinants of value are time and quality. A good incentive for building an authentic quantitative credit layer is the capital value and risk that remain buried in the mathematics of discounting.