A comparison of UK equity and property duration

Abstract

DedicationThis paper is dedicated to Nanda Nanthakumaran who died before it was published. He was, not only a dedicated teacher and researcher of international renown, but also a dear friend, sadly missed by everyone who knew him. We hope that the alterations we have made subsequent to his death are in keeping with the high standards he always set. A comparison of UK property and equity duration AbstractThis paper considers the duration of property and equity. A general formula for duration of asset classes is derived. It is shown that calculations which assume, usually implicitly, that the flow-through of inflation to cash flow is zero, produce misleadingly high durations for property and equities. These are typically in the range 15 to 25 years. Simulations using the formulae show that property has some bond-like characteristics. The results indicate that, for realistic flow-through rates, equities have a higher duration than property. The flow-through rate is the most important variable in the estimation of equities. Using historical data, equity duration is estimated at 8.65 years and property's at 3.15 years. These are substantially lower than those commonly cited. If these values can be substantiated, and if higher values are used in practice, portfolio immunisation strategies may need to be reconsidered.

Equity duration and convexity when firms can fail or stagnate

“…(Boquist et al, 1975), where g is the annual growth rate of the firm's cash flows and r is the interest rate discounting future cash flows, neglecting the possibility that the firm may ever fail. 2 Though conceptually elegant and conveniently simple, this expression predicts unrealistically long durations when compared against historical data (Leibowitz et al, 1989;Hamelink et al, 2002). For example, if a firm's cash flows grow at an annual rate 2 percentage points less than the discount rate, the equity's duration would be calculated at roughly 50 years; empirical studies, by contrast, have often found equity durations less than 10 years (Leibowitz et al, 1989;Cornell, 2000;Hamelink et al, 2002).…”

“…For example, if a firm's cash flows grow at an annual rate 2 percentage points less than the discount rate, the equity's duration would be calculated at roughly 50 years; empirical studies, by contrast, have often found equity durations less than 10 years (Leibowitz et al, 1989;Cornell, 2000;Hamelink et al, 2002). One attempt to reconcile theory with empirical reality has been to adjust the growth rate of cash flows by some assumed response to inflation, recognizing that both the nominal discount rate and cash flows typically change in the same direction as any change in the expected rate of inflation (Leibowitz et al, 1989;Hamelink et al, 2002). Another refinement has been to incorporate a certainty equivalent factor (CE) to correct empirically for beta risk, as in Casabona et al (1984).…”

“…2 Though conceptually elegant and conveniently simple, this expression predicts unrealistically long durations when compared against historical data (Leibowitz et al, 1989;Hamelink et al, 2002). For example, if a firm's cash flows grow at an annual rate 2 percentage points less than the discount rate, the equity's duration would be calculated at roughly 50 years; empirical studies, by contrast, have often found equity durations less than 10 years (Leibowitz et al, 1989;Cornell, 2000;Hamelink et al, 2002). One attempt to reconcile theory with empirical reality has been to adjust the growth rate of cash flows by some assumed response to inflation, recognizing that both the nominal discount rate and cash flows typically change in the same direction as any change in the expected rate of inflation (Leibowitz et al, 1989;Hamelink et al, 2002).…”

“…The concept of duration provides a long-established measure of that risk, usually applied to fixed-income securities but occasionally extended to equities; see Macaulay (1938), Hicks (1939), Boquist et al (1975), Casabona et al (1984), Leibowitz et al (1989), and Hamelink et al (2002). Likewise, at least two studies have analyzed the convexity of equities (Johnson, 1990;Hurley and Johnson, 1995).…”

A New Measure of Equity Duration: The Duration-Based Explanation of the Value Premium Revisited

“…In a series of papers, Leibowitz (Leibowitz, 1986;Leibowitz et al, 1989;Leibowitz and Kogelman, 1993) presents first attempts to estimate an equity duration for individual firms. Other recent studies include Cohen (2002), Hamelink et al (2002), Dechow et al (2004), Lewin et al (2007), and Shaffer (2007).…”