Duration

Definition

Duration is a measure of the sensitivity of a bond's price to changes in interest rates, reflecting the weighted average time until cash flows are received. It helps investors understand how long it takes for a bond to repay its price through its cash flows and is crucial for assessing interest rate risk, particularly in the context of different bond types and valuation methods.

5 Must Know Facts For Your Next Test

1. Duration is typically expressed in years and provides a single number that summarizes the timing and amount of cash flows from a bond.
2. Longer duration bonds are generally more sensitive to interest rate changes compared to shorter duration bonds, making them riskier in rising rate environments.
3. Investors can use duration as a tool for immunizing portfolios against interest rate risk by matching the duration of assets and liabilities.
4. Zero-coupon bonds have a duration equal to their maturity because they only pay a single cash flow at maturity, making their duration very straightforward.
5. Duration is not the same as maturity; while maturity refers to when the bond will be paid off, duration focuses on the timing of cash flows and their present value.

Review Questions

• How does duration help investors evaluate interest rate risk when selecting different types of bonds?
  • Duration provides insight into how sensitive a bond's price is to changes in interest rates, allowing investors to assess potential risks associated with their investments. By understanding the duration of various bond types, investors can better navigate interest rate fluctuations, choosing bonds that align with their risk tolerance. For instance, a bond with a longer duration will likely see more price volatility in response to changing rates than one with a shorter duration.
• Compare Macaulay duration and modified duration, highlighting their distinct roles in bond valuation and risk assessment.
  • Macaulay duration measures the weighted average time until cash flows are received, while modified duration adjusts this figure to show how much a bond's price is expected to change with a 1% shift in yield. Both metrics are crucial for understanding bond behavior; Macaulay duration helps in evaluating when an investor will recover their investment, whereas modified duration offers insights into price volatility due to interest rate changes. Together, they provide a comprehensive picture of bond valuation and risk.
• Evaluate the implications of using duration as a strategy for immunizing a portfolio against interest rate risk and discuss potential limitations.
  • Using duration as an immunization strategy allows investors to balance the sensitivity of their assets and liabilities to interest rate movements, aiming for minimal overall portfolio risk. By matching durations, investors can protect themselves from adverse effects due to rising or falling interest rates. However, this strategy has limitations; it may not account for changes in yield curves or the reinvestment risk of cash flows. Additionally, using a static duration measure can oversimplify dynamic market conditions, potentially leading to unexpected losses.

Related terms

Macaulay Duration: A specific type of duration that calculates the weighted average time until cash flows are received, measured in years.

Modified Duration: An adjusted version of Macaulay Duration that accounts for changes in interest rates, indicating how much a bond's price will change for a 1% change in yield.

Yield to Maturity (YTM): The total return anticipated on a bond if it is held until maturity, which is used in calculating both Macaulay and modified duration.