9.4 The Weighted Average of the ALCF: A Visual Analog

When we speak of “average life of the cash flows,” we are not speaking of the point at which half the cash flows are collected. We are speaking in terms of the weighted average of the cash flows. The fulcrum represents that point.

Below is a “seesaw” with five payments. The shorter rectangles represent coupon payments. The higher rectangle represents the final payment plus the last coupon. The fulcrum causes the seesaw to be horizontal. That is the point of the ALCF. Both sides of the fulcrum are in balance.

Take note that the average, which is denoted by the position of the fulcrum, is between coupon payments. The average represents the group, but not any individual payment. This is a characteristic of averages. For example, you can take the average weight of two people, one 150 pounds, the other 170. The average, 160, represents neither individual.