Duration is one of the fundamental characteristics of a fixed-income security (e.g., a bond) alongside maturity, yield, coupon, and call features. It is a tool used in the assessment of the price volatility of a fixed-income security.
Since the interest rate is one of the most significant drivers of a bond’s value, duration measures the sensitivity of the value fluctuations to changes in interest rates. The general rule states that a longer duration indicates a greater likelihood that the value of a bond will fall as interest rates increase.
Duration is commonly used in the portfolio and risk management of fixed-income instruments. Using interest rate forecasts, a portfolio manager can change a portfolio’s composition to align its duration with the expected level of interest rates.
However, duration only reveals one side of a fixed-income security. A full analysis of the fixed-income asset must be done using all available characteristics.
The duration metric comes in several modifications. The most common are the Macaulay duration, modified duration, and effective duration.
1. Macaulay Duration
Macaulay duration is a weighted average of the times until the cash flows of a fixed-income instrument are received. The concept was introduced by Canadian economist Frederick Macaulay. It is a measure of the time required for an investor to be repaid the bond’s price by the bond’s total cash flows. The Macaulay duration is measured in units of time (e.g., years).
The Macaulay duration for coupon-paying bonds is always lower than the bond’s time to maturity. For zero-coupon bonds, the duration equals the time to maturity.
The formula for the calculation of Macaulay duration is expressed in the following way:
ti– The time until the ith cash flow from the asset will be received
PVi – The present value of the ith cash flow from the asset
V – The present value of all cash flows from the asset
2. Modified Duration
Relative to the Macaulay duration, the modified duration metric is a more precise measure of price sensitivity. It is primarily applied to bonds, but it can also be used with other types of securities that can be considered as a function of yield.
The modified duration figure indicates the percentage change in the bond’s value given an X% interest rate change. Unlike the Macaulay duration, modified duration is measured in percentages.
The modified duration is often considered as an extension of the Macaulay duration. It is supported by the following mathematical formula:
YTM – The yield to maturity of a bond
n – The frequency of compounding
3. Effective Duration
Effective duration is a measure of the duration for bonds with embedded options (e.g., callable bonds). Unlike the modified duration and Macaulay duration, effective duration considers fluctuations in the bond’s price movements relative to the changes in the bond’s yield to maturity (YTM). In other words, the measure takes into account possible fluctuations in the expected cash flows of a bond.
The effective duration is calculated using the following formula:
V–Δy– The bond’s value if yield falls by y%
V+Δy– The bond’s value if yield rises by y%
V0– The present value of all cash flows of the bond
Δy– The yield change
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