Business Glossary

typical operating service life of an asset for the purpose it was acquired. The term usually applies to fixed assets. The useful life used fordepreciation accountingdoes not necessarily coincide with the actual physical life or any commonly recognizedeconomic life

1. spreading out of the original cost over the estimated life of the fixed assets such as plant and equipment. Depreciation reduces taxable income. Among the most commonly used depreciation methods are straight-line depreciationand accelerated depreciationsuch as the sum-of-the-years'-digits (SYD) methodand double declining balance method.
2. decline in economic potential of limited life assets originating from wear and tear, natural deterioration through interaction of the elements,and technical obsolescence. To some extent, maintenance (lubrication, adjustments, parts replacement, and cleaning) may partially arrest or offset wear and deterioration.

estimated period that a fixed asset will provide benefits to the company. It is usually less than the physical life of an asset because an asset continues to havephysical lifedespite inefficiency and obsolescence. Depreciation expense is typically based on the economic life.

point in time in which half the principal has been repaid in a mortgage-backed security guaranteed or issued by the government national mortgage association, the Federal National Mortgage Association, or the Federal Home Loan Mortgage Corporation. Normally, it is assumed that such a security has a half-life of 12 years. But specific mortgage pools can have vastly longer or shorter halflives, depending on interest rate trends. If interest rates fall, more homeowners will refinance their mortgages, meaning that principal will be paid off more quickly, and half-lives will drop. If interest rates rise, homeowners will hold onto their mortgages longer than anticipated, and half-lives will rise.

number of years needed for half of the loan principal in a mortgage backed security to be repaid. Half lives are determined by interest rate volatility, borrower prepayments, and to some extent by geographic region. The half life of a pool of mortgages backing a ginnie mae pass-throughsecurity was presumed to be 12 years. The half life of a so-called current coupon mortgage is closer to 10 years, but heavy prepayments can shorten half lives to as little as 4 to 5 years. In general, when interest rates fall, borrowers refinance at substantial savings in interest costs, causing half lives to drop.Rising rates have the opposite effect. Borrowers hold on to their loans for a longer period and half lives lengthen.

concept first developed by Frederick Macaulay in 1938 that measures bond price volatility by measuring the "length" of a bond. It is a weighted-average term-to-maturity of the bond's cash flows, the weights being the present value of each cash flow as a percentage of the bond's full price. A Salomon Smith Barney study compared it to a series of tin cans equally spaced on a seesaw. The size of each can represents the cash flow due, the contents of each can represent the present values of those cash flows, and the intervals between them represent the payment periods. Duration is the distance to the fulcrum that would balance the seesaw. The duration of a zero-coupon security would thus equal its maturity because all the cash flows-all the weights-are at the other end of the seesaw. The greater the duration of a bond, the greater its percentage volatility. In general, duration rises with maturity, falls with the frequency of coupon payments, and falls as the yield rises (the higher yield reduces the present values of the cash flows.) Duration (the term modified duration is used in the strict sense because of modifications to Macaulay's formulation) as a measure of percentage of volatility is valid only for small changes in yield. For working purposes, duration can be defined as the approximate percentage change in price for a 100-basis-point change in yield. A duration of 5, for example, means the price of the bond will change by approximately 5% for a 100-basis point change in yield.

For larger yield changes, volatility is measured by a concept called convexity. That term derives from the price-yield curve for a normal bond, which is convex. In other words, the price is always falling at a slower rate as the yield increases. The more convexity a bond has, the merrier, because it means the bond's price will fall more slowly and rise more quickly on a given movement in general interest rate levels. As with duration, convexity on straight bonds increases with lower coupon, lower yield, and longer maturity. Convexity measures the rate of change of duration, and for an option-free bond it is always positive because changes in yield do not affect cash flows. When a bond has a call option, however, cash flows are affected. In that case, duration gets smaller as yield decreases, resulting in negative convexity.

When the durations of the assets and the liabilities of a portfolio, say that of a pension fund, are the same, the portfolio is inherently protected against interest-rate changes and you have what is called immunization. The high volatility and interest rates in the early 1980s caused institutional investors to use duration and convexity as tools in immunizing their portfolios.

monthly rate of return of a mortgage-backed security, based on principal and interest mortgage payments and an estimated rate of loan prepayment. Cash flow yield is the monthly Internal Rate of Return (IRR)of a mortgage-backed security, assuming a standard rate of mortgage prepayments. The cash flows from mortgages are discounted to their net present value, producing the rate of return that approximates the actual return to the holder. Prepayment assumptions are adjusted according to differing types of collateral, for example, Federal Housing Authority insured loans or conventional mortgages. Because some mortgage pools are paid off faster than others, cash flow yield offers a more realistic way to price mortgage backed securities than the 12-year prepayment assumptions prevalent in the 1970s.