Introduction

Bond duration is a measure of a bond’s sensitivity to changes in interest rates. It is often used as a tool by investors to manage the risks associated with fluctuations in the bond market.

Bond duration is calculated by taking the weighted average of the time periods over which a bond’s cash flows are received. The weighting is based on the present value of each cash flow. For example, a bond with ten years remaining to maturity and a coupon rate of 5% would have a duration of approximately 8.6 years.

duration = (1/10)*(1+0.05)^10+(9/10)*(1+0.05)^9+(8/10)*(1+0.05)^8+…+(1/10)*(1+0.05)

The longer the duration of a bond, the greater its sensitivity to changes in interest rates. For example, if interest rates rise by 1%, the price of a bond with a duration of 10 years would fall by approximately 10%. Conversely, if interest rates fall by 1%, the price of a bond with a duration of 10 years would rise by approximately 10%.

Duration is an important concept for bond investors to understand because it can be used to manage interest rate risk. For example, an investor who is concerned about rising interest rates may choose to invest in bonds with shorter durations. Conversely, an investor who is concerned about falling interest rates may choose to invest in bonds with longer durations.

What is Duration?

Duration is a measurement of a bond’s sensitivity to changes in interest rates. It is often called a bond’s “time to maturity” because it measures how long it will take for a bond’s price to be repaid by its issuer at par value.

Definition of Duration

The duration of a bond is the amount of time until the bond matures and the principal is repaid. The term is used for both debt and preferred stock. For a bond that pays periodic interest payments,duration is the weighted average of the times until those cash flows are received. The present value of each cash flow (taking into account the interest rate on the bond) is weighted by its fraction of the total interest payments. For zero-coupon bonds, which make no periodic interest payments, duration equals maturity.

Duration and Interest Rate Risk

Duration is a measure of a bond’s interest rate risk. It is defined as the percentage change in the price of a bond for a 1% change in interest rates. For example, if a bond has a duration of 5 years, then its price will decline by 5% if interest rates rise by 1%.

The longer the duration of a bond, the greater its interest rate risk. This is because the bond’s coupon payments will be reinvested at lower rates if interest rates rise. As a result, the bond’s overall return will be lower.

duration can also be expressed in terms of years. For example, a 5-year bond with a 10% coupon will have a duration of 5.5 years (10% x 5 years).

Duration is an important concept for bond investors to understand because it can help them to manage their portfolios more effectively. By knowing the duration of their bonds, investors can make more informed decisions about when to buy and sell them.

Duration and Convexity

Definition of Convexity

Convexity is a measure of the curvature in the relationship between bond prices and yields. It is used in the pricing of bonds and derivatives to determine the sensitivity of a bond’s price to changes in interest rates. A bond’s convexity measures how much its price changes in response to changes in interest rates. The higher the convexity, the greater the sensitivity. A bond with a higher convexity will have a higher price when interest rates are low, and a lower price when interest rates are high.

Relationship between Duration and Convexity

Bond duration is a measure of a bond’s sensitivity to changes in interest rates. The longer the duration, the greater the sensitivity. Convexity is a measure of the curvature of a bond’s price-yield relationship. The greater the convexity, the more pronounced the curvature.

Most bonds have positive convexity, meaning that as rates rise, prices fall more than what would be predicted by duration alone. This relationship exists because bonds with longer maturities have a greater sensitivity to changes in interest rates than shorter maturity bonds. When rates rise, prices of long-maturity bonds fall further than prices of shorter-maturity bonds. Conversely, when rates fall, prices of long-maturity bonds rise more than prices of shorter-maturity bonds.

The relationship between duration and convexity can be illustrated by looking at two hypothetical bonds with different durations and convexities: Bond A has a duration of five years and a convexity of 10; Bond B has a duration of 10 years and a convexity of 20. Assume that both bonds have an initial yield to maturity (YTM) of 5%. If interest rates increase by 1%, Bond A’s price will decline by approximately 5% ((5% x 5 years) + (10% x 1%)), or 6%. Bond B’s price will decline by approximately 10% ((5% x 10 years) + (20% x 1%)), or 15%. Conversely, if interest rates decline by 1%, Bond A’s price will increase by 6%, while Bond B’s price will increase by 15%. As this example shows, all else being equal, the bond with the higher convexity experiences bigger percentage price changes for a given change in interest rates than the bond with lower convexity.

View comparable articles on article about interest payments on bonds, or article what is interest accrued.

Conclusion

To conclude, duration is a measure of a bond’s sensitivity to changes in interest rates. It is calculated by taking into account the present value of all future cash flows and weighting them by the time until they are received. The longer the duration, the greater the interest rate risk.