Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. This concept is used widely in the finance and investment sectors. It is expressed as a number of years and helps map the expected time for cash flows from an investment like bonds or other fixed-income instruments.
For example, if a bond has a duration of 6 years, it indicates that for every 1% increase or decrease in interest rate, the bond’s price will increase or decrease by about 6%. Thus, the concept of duration helps estimate potential volatility and manage risks associated with interest rate fluctuations.
Related Questions
1. How is duration calculated?
Duration is calculated by adding the present value of all future cash flows from a bond, multiplied by the time they are received, and dividing it by the total present value of the bond. This gives an average maturity period that helps understanding how changes in interest rates will affect the bond’s prices.
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2. What is the difference between Duration and Maturity?
Maturity refers to the time when the bond will be redeemed by the issuer, thereby ceasing to exist. While duration represents the time it takes, on average, to receive the bond’s cash flows. Thus, while maturity is an absolute measure, duration considers the present value of future payments.
3. What is Macaulay Duration?
Named after Frederick Macaulay who introduced the concept, Macaulay Duration is the weighted average time to receive the cash flows from a bond. The weights here represent the present value of the cash flow divided by the total present value of all cash flows.
4. What does a high Duration mean?
A high duration means that the bond’s price is highly sensitive to changes in interest rates. This means the bond carries more risk because its price will change significantly with any change in the interest rate.
5. What does a low Duration represent?
A low duration simply implies that the bond’s price is less sensitive to interest rate changes. These types of bonds or fixed-income securities are generally considered lower risk considering their price does not vary massively with interest rate fluctuations.