Duration Analysis of Risk

23/11/2020

Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates. A bond’s duration is easily confused with its term or time to maturity because they are both measured in years. However, a bond’s term is a linear measure of the years until repayment of principal is due; it does not change with the interest rate environment. Duration, on the other hand is non-linear and accelerates as time to maturity lessens.

Duration measures how long it takes, in years, for an investor to be repaid the bond’s price by the bond’s total cash flows. At the same time, duration is a measure of sensitivity of a bond’s or fixed income portfolio’s price to changes in interest rates. In general, the higher the duration, the more a bond’s price will drop as interest rates rise (and the greater the interest rate risk). As a general rule, for every 1% change in interest rates (increase or decrease), a bond’s price will change approximately 1% in the opposite direction, for every year of duration. If a bond has a duration of five years and interest rates increase 1%, the bond’s price will drop by approximately 5% (1% X 5 years). Likewise, if interest rates fall by 1%, the same bond’s price will increase by about 5% (1% X 5 years).

Certain factors can affect a bond’s duration, including:

• Time to maturity. The longer the maturity, the higher the duration, and the greater the interest rate risk. Consider two bonds that each yield 5% and cost \$1,000, but have different maturities. A bond that matures faster say, in one year would repay its true cost faster than a bond that matures in 10 years. Consequently, the shorter-maturity bond would have a lower duration and less risk.
• Coupon rate. A bond’s coupon rate is a key factor in calculation duration. If we have two bonds that are identical with the exception on their coupon rates, the bond with the higher coupon rate will pay back its original costs faster than the bond with a lower yield. The higher the coupon rate, the lower the duration, and the lower the interest rate risk.

The duration of a bond in practice can refer to two different things. The Macaulay duration is the weighted average time until all the bond’s cash flows are paid. By accounting for the present value of future bond payments, the Macaulay duration helps an investor evaluate and compare bonds independent of their term or time to maturity.

The second type of duration is called “modified duration” and, unlike Macaulay duration, is not measured in years. Modified duration measures the expected change in a bond’s price to a 1% change in interest rates. In order to understand modified duration, keep in mind that bond prices are said to have an inverse relationship with interest rates. Therefore, rising interest rates indicate that bond prices are likely to fall, while declining interest rates indicate that bond prices are likely to rise.

Macaulay Duration

Macaulay duration finds the present value of a bond’s future coupon payments and maturity value. Fortunately for investors, this measure is a standard data point in most bond searching and analysis software tools. Because Macaulay duration is a partial function of the time to maturity, the greater the duration, the greater the interest-rate risk or reward for bond prices.

Macaulay duration can be calculated manually as follows: