Duration

Definition

Duration is a measure of the sensitivity of a bond's price to changes in interest rates, reflecting the average time it takes for a bond's cash flows to be received. It connects the time value of money to interest rate risk, serving as an essential tool for understanding how bond prices fluctuate in response to shifts in market rates. This concept plays a vital role in evaluating investments, pricing bonds, and assessing the overall risk exposure of fixed-income securities.

5 Must Know Facts For Your Next Test

1. Duration is expressed in years, and a higher duration indicates greater sensitivity to interest rate changes.
2. For zero-coupon bonds, the duration is equal to its maturity because there is only one cash flow at maturity.
3. Duration can help investors manage interest rate risk by adjusting their portfolios based on anticipated changes in interest rates.
4. When comparing bonds, investors often prefer those with shorter durations when expecting rising interest rates due to reduced price volatility.
5. The relationship between duration and convexity indicates that duration alone may not fully capture price changes when interest rates experience large movements.

Review Questions

• How does duration influence bond pricing in response to interest rate changes?
  • Duration plays a critical role in determining how sensitive a bond's price is to changes in interest rates. As interest rates rise, bonds with longer durations will typically see larger declines in their prices compared to those with shorter durations. Understanding this relationship helps investors gauge potential risks associated with holding specific bonds in varying interest rate environments.
• Discuss how forward rates relate to the concept of duration and the term structure of interest rates.
  • Forward rates are future interest rates implied by current term structures and are essential for understanding expected returns on bonds over different periods. Duration ties into this by helping investors assess how fluctuations in these forward rates impact the pricing of fixed-income securities. A bond’s duration reflects its average cash flow timing, meaning that shifts in forward rates can significantly affect a bond’s price, especially for longer-duration securities.
• Evaluate how variations in mortgage-backed securities' durations impact investor strategies during periods of economic uncertainty.
  • Mortgage-backed securities (MBS) have unique prepayment characteristics that influence their durations compared to traditional bonds. During periods of economic uncertainty, the likelihood of prepayments may increase or decrease, altering the expected cash flow timings and thereby affecting the MBS's effective duration. Investors must consider these dynamics to effectively manage their portfolios and mitigate risks associated with changing interest rates and borrower behaviors, ensuring their strategies align with market expectations and economic indicators.

Related terms

Macaulay Duration:

The weighted average time until a bond's cash flows are received, which considers the present value of each cash flow relative to the total present value.

Modified Duration:

A modified version of Macaulay duration that directly measures a bond's price sensitivity to changes in interest rates, indicating how much the price will change for a 1% change in yield.

Convexity:

A measure of the curvature in the relationship between bond prices and interest rates, which enhances the accuracy of estimating price changes beyond what duration can provide.