DURATION BASICS

PREPARED BYHARSHITA CHATURVEDI

DEFINITION
It is a measure of a bond's sensitivity to interest

rate changes. The higher the bond's duration, the greater its sensitivity to the change and vice versa most commonly used measure of risk in bond investing. It incorporates a bond's yield, coupon, final maturity and call features into one number, expressed in years.

 Rising interest rates mean falling bond prices,

while declining interest rates mean rising bond prices.

For example, a 5 year duration means

the bond will decrease in value by 5% if interest rates rise 1% and increase in value by 5% if interest rates fall 1%.
If an investor expects interest rates to fall during

the course of the time the bond is held, a bond with a long duration would be appealing.

HOW IT WORKS
There is more than one way to calculate duration,

depending on one's compounding assumptions, but the Macaulay Duration is the most common. Macaulay Duration. Developed in 1938 by Frederic Macaulay, this form of duration measures the number of years required to recover the true cost of a bond, considering the present value of all coupon and principal payments received in the future.

where: t = period in which the coupon is received C = periodic (usually semiannual) coupon payment y = the periodic yield to maturity or required yield n = number periods M = maturity value (in $) P = market price of bond

EXPLANATION
Duration = Present value of a bond's cash flows,

weighted by length of time to receipt and divided by the bond's current market value. For example, let's calculate the duration of a three-year, $1,000 Company XYZ bond with a semiannual 10% coupon.

 Company XYZ Macaulay duration = $5,329.48 /

$1,000 = 5.33 As we know duration can help understand sensitivity of a bond to changes in prevailing interest rates, thus multiplying a bond's duration by the change, we can estimate the percentage price change for the bond. For example, the Company XYZ bonds with a duration of 5.53 years. If market yields increased by 20 basis points (0.20%), the approximate percentage change in the XYZ bond's price would be: -5.53 x .002 = -0.01106 or -1.106%

FACTORS AFFECTING DURATION

six things affect a bond's duration: Bond's Price: if the bond in the above example

were trading at $900 today, then duration=$5,329.48 / $900 = 5.92. If $1,200 today, then duration =$5,329.48 / $1,200 = 4.44. Coupon: The higher a bond's coupon, the more income it produces early on and thus the shorter its duration. The lower the coupon, the longer the duration (and volatility). Zero-coupon bonds, which have only one cash flow, have durations equal to their maturities.

 Maturity: The longer a bond's maturity, the

greater its duration (and volatility). Duration changes every time a bond makes a coupon payment. Over time, it shortens as the bond nears maturity.
Yield to Maturity: The higher a bond's yield to

maturity, the shorter its duration because the present value of the distant cash flows (which have the heaviest weighting) become overshadowed by the value of the nearer payments.
Sinking Fund: The presence of a sinking fund

lowers a bond's duration because the extra cash

 Call provision: Bonds with call provisions also

have shorter durations because the principal is repaid earlier than a similar non-callable bond.
LIMITATIONS OF MACAULAYS DURATION:

The formula assumes a linear relationship between bond prices and yields even though the relationship is actually convex. Thus, the formula is less reliable when there is a large change in yield.

WHY IS IT IMPORTANT
An investor benefits from duration in 2 ways: Speculating on interest rates: Investors who

anticipate a decline in market interest rates would try to increase the average duration of their bond portfolio. Likewise, investors who expect a rise in interest rates would want to lower their average duration. Matching risk to your tastes: When selecting from bonds of different maturities and yields, or comparing bond mutual funds, duration allows you to quickly determine which bonds are more sensitive to changes in market interest rates, and to what degree.

CONCLUSION
The Securities Industry and Financial Markets

Association, a trade group of financial professionals, has posted an article titled Risks of Investing in Bonds, which offers further information on duration risk. Regent School Press, an academic publisher, offers a technical analysis of bond duration in a PDF file. Karvy, a financial services company, provides a calculator for figuring how to use bond duration to hedge risks in other investments.