Duration

Sunny Kumar Singh

Department of Economics & Finane
BITS Pilani, Hyderabad Campus
Fundamentals of Finance & Accounting (ECON F212)
Topic: Duration

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Duration
The estimation of the effect of maturity and coupon rates on the sensitivity of bond
prices to changes in interest rates (we have discussed so far), is complex and using
these relationships as the basis for decision making is difficult in dealing with multiple
bonds.
Duration, on the other hand, provides a simple measure that allows for a
straightforward calculation of a bond’s interest rate sensitivity.
In this section, we show that the price sensitivity of a bond, or the percent change in
the bond’s fair present value, for a given change in interest rates (as discussed above)
can be more directly measured by a concept called duration (or Macauley’s duration).
We also show that duration produces an accurate measure of the price sensitivity of a
bond to interest rate changes for relatively small changes in interest rates.
The duration measure is a less accurate measure of price sensitivity, the larger the
change in interest rates.

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Duration
Duration is the weighted-average time to maturity on a financial security using the
relative present values of the cash flows as weights.
On a time value of money basis, duration measures the weighted average of when cash
flows are received on a security.
or
Duration is the weighted-average time to maturity (measured in years) on a financial security.
In addition to being a measure of the average life of an asset or liability, duration also
has economic meaning as the sensitivity, or elasticity, of that asset or liability’s value
to small interest rate changes (either required rate of return or yield to maturity).
Duration describes the percentage price, or present value, change of a financial
security for a given (small) change in interest rates. That is, rather than calculating
present value changes resulting from interest rate changes, as we did in the previous
sections, the duration of a financial security can be used to directly calculate the price
change.
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A Simple Illustration of Duration
Consider a bond with one year remaining to maturity, a $1,000 face value, an 8 percent coupon rate
(paid semiannually), and an interest rate (either required rate of return or yield to maturity) of 10
percent. The promised cash flows from this bond are illustrated in the below figure. The bond holder
receives the promised cash flows ( CF ) from the bond issuer at the end of one-half year and at the end
of one year.
CF is the $40 promised payment of (semiannual) coupon interest ($1000 X 8% X 1/2) received after six
months. CF1/2 is the promised cash flow at the end of year 1; it is equal to the second $40 promised
(semiannual) coupon payment plus the $1,000 promised payment of face value. To compare the relative
sizes of these two cash flow payments—since duration measures the weighted-average time to maturity
of a bond—we should put them in the same dimensions, because $1 of principal or interest received at
the end of one year is worth less to an investor in terms of time value of money than is $1 of principal
or interest received at the end of six months.

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Duration is the weighted-average time to maturity (measured in years) on a financial security
The bond holder receives some cash flows at one-half year and some at one year. Intuitively,
duration is the weighted-average maturity on the portfolio of zero coupon bonds, one that has
payments at one-half year and at the end of the year (year 1) in this example.

Specifically, duration analysis weights the time at which cash flows are received by the relative
importance in present value terms of the cash flows arriving at each point in time. In present
value terms, the relative importance of the cash flows arriving at time t= ½ year and time t = 1
year are as follows:

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Duration is the weighted-average time to maturity (measured in years) on a financial security cont…

In present value terms, the bond holder receives 3.88 percent of the cash flows on the bond
with the first coupon payment at the end of six months (t½) and 96.12 percent with the second
payment of coupon plus face value at the end of the year (t1). By definition, the sum of the
(present value) cash flow weights must equal 1:

We can now calculate the duration (D), or the weighted-average time to maturity of the bond,
using the present value of its cash flows as weights:

Thus, although the maturity of the bond is one year, its duration or average life in a cash flow
sense is only .9806 years.
Duration is less than maturity because in present value terms, 3.88 percent of the cash flows
are received during the year.
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A General Formula for Duration
Formula slightly differs when the time period changes

We can calculate the duration for any We can calculate the duration for any fixed-
fixed-income security that pays interest income security that pays interest Semi-annually
annually using the following formula: using the following formula:

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The Duration of a Zero-Coupon Bond
Zero-coupon bonds sell at a discount from face value on issue and pay their face value (e.g., $1,000)
on maturity. These bonds have no intervening cash flows, such as coupon payments, between issue
and maturity. The current price that an investor is willing to pay for such a bond, assuming semiannual
compounding of interest, is equal to the present value of the single, fixed (face value) payment on the
bond that is received on maturity (here, $1,000):

Because the only cash flow received on these securities is the final payment at maturity (time T zc), the
following must be true:

That is, the duration of a zero-coupon bond equals its maturity. Note that it is only for zero coupon
bonds that duration and maturity are equal. Indeed, for any bond that pays some cash flows prior to
maturity, its duration will always be less than its maturity.
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The Duration of a Zero-Coupon Bond – Text Book Example
Suppose that we have a zero-coupon bond with a face value of $1,000, a
maturity of four years, and a current rate of return of 8 percent compounded
semiannually. Since the bond pays no interest, the duration equation consists of
only one term—cash flows at the end of year 4:

or duration equals the maturity of the zero-coupon bond.

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The Duration of a Four-Year Bond –Text Book Example
 Suppose that we have a bond that offers a coupon rate of 10 percent paid semiannually (or 5 percent paid
every 6 months). The face value of the bond is $1,000, it matures in four years, its current rate of return (r b) is 8
percent, and its current price is $1,067.34.
 Below the calculation indicates, the duration, or weighted-average time to maturity, on this bond is 3.42 years.
In other words, on a time value of money basis, the initial investment of $1,067.34 is recovered after 3.42
years.
Duration of a Four-Year Bond with 10 Percent Coupon Paid Semiannually and 8 Percent Yield

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Changes in the coupon rates Vs Bond Durations

..

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Changes in the discount rates Vs Bond Durations

..

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Changes in the maturity periods Vs Bond Durations

..

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Features of Duration
The higher the coupon or promised interest payment on a
security, the shorter is its duration.

The higher the rate of return on a security, the shorter is its

duration.

Duration increases with maturity at a decreasing rate.

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Economic Meaning of Duration (Second Meaning of Duration)
In addition to being a measure of the average life of a bond, duration is also a direct
measure of its interest rate sensitivity, or elasticity.
In other words, the larger the numerical value of duration ( D ), the more sensitive the price
of that bond to (small) changes or shocks in interest rates.
The specific relationship between these factors for securities with annual compounding of
interest is represented as*:

 For securities with semiannual receipt (compounding) of interest, it is represented as:

*In practical life, we use the ∆ (change) notation instead of d (derivative notation) to recognize that interest rate changes tend
to be discrete rather than infinitesimally small. For example, in real world financial markets the smallest observed rate change is
usually one basis point, or 1/100 of 1 percent (Those who follow the financial newspapers or news channel, quite often they
hear that RBI is going to increase or decrease the policy rates by X number of bps or basis points. 100 basis points == 1%.
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Economic Meaning of Duration (Second Meaning of Duration)

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Economic Meaning of Duration (Second Meaning of Duration)
The definition of duration can be rearranged in another useful way for interpretation
regarding interest sensitivity:
For Annual Compounding Semi-Annual Compounding

or

This equation shows that for small changes in interest rates, bond prices move in an
inversely proportional manner according to the size of D .
Clearly, for any given change in interest rates, long duration securities suffer a larger capital
loss (or receive a higher capital gain) should interest rates rise (fall) than do short duration
securities.

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Modified Duration (MD)

The above duration equation can be rearranged, combining D and into a single
variable to produce what practitioners call modified duration (MD). For annual
compounding of interest:

For semiannual compounding of interest:

This form is more intuitive than the Macauley’s duration because we multiply MD by the simple change in
interest rates rather than the discounted change in interest rates as in the general duration equation.
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Thus, the modified duration is a more direct measure of bond price elasticity. 18
Modified Duration (MD) – Text book numerical example-1
Consider a four-year bond with a 10 percent coupon paid semiannually (or 5 percent paid every 6
months) and an 8 percent rate of return (). According to slide number 38, 39 and 41, the bond’s
duration is D=3.42 years. Suppose that the rate of return increases by 10 basis points (1/10 of 1
percent) from 8 to 8.10 percent; then, using the semiannual compounding version of the duration
model shown above, the percentage change in the bond’s price is:
or

The bond price had been $1,067.34, which was the present value of a four-year bond with a 10 percent
coupon and an 8 percent rate of return. However, the duration model predicts that the price of this bond
will fall by 0.329 percent, or by $3.51, to $1,063.83 after the increase in the rate of return on the bond of
10 basis points. Observe that we don’t have to do all those present value calculations for the newly
quoted rrr. It is so simple and straight forwarded.

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Modified Duration (MD) – Text book numerical example-2
Consider a four-year bond with a 6 percent coupon paid semiannually (or 3 percent paid every 6
months) and an 8 percent rate of return (). According to slide number 39, the bond’s duration is
D=3.60 years. Suppose that the rate of return increases by 10 basis points (1/10 of 1 percent) from 8
to 8.10 percent; then, using the semiannual compounding version of the duration model shown
above, the percentage change in the bond’s price is:
or

for a 10-basis-point increase in the rate of return for each semiannual period. The bond’s price drops by
0.346 percent, or by $3.23, from $932.68 (reported in slide no 39) to $929.45.
Notice again that, all else held constant, the higher the coupon rate on the bond, the shorter the
duration of the bond and the smaller the percentage decrease in a bond’s price for a given increase in
interest rates.

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Large Interest Rate Changes and Duration
It needs to be stressed here that duration accurately measures the price sensitivity of financial
securities only for small changes in interest rates of the order of one or a few basis points (a
basis point is equal to one-hundredth of 1 percent).
Suppose, however, that interest rate shocks are much larger, of the order of 2 percent or 200
basis points or more. While such large changes in interest rates are not common, this might
happen in a financial crisis or if the central bank (we will see in the next class) suddenly
changes its monetary policy strategy.
In this case, duration becomes a less accurate predictor of how much the prices of bonds will
change, and therefore, a less accurate measure of the price sensitivity of a bond to changes in
interest rates.

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Large Interest Rate Changes and Duration

As above figure shows, in actuality, the capital loss effect of large rate increases tends to be smaller
than the capital gain effect of large rate decreases. This is the result of a bond’s price–interest rate
relationship exhibiting a property called convexity rather than linearity, as assumed by the simple
duration model. Intuitively, this is because the sensitivity of the bond’s price to a change in interest rates
depends on the level from which interest rates change (i.e., 6 percent, 8 percent, 10 percent, and 12
percent). In particular, the higher the level of interest rates, the smaller a bond’s price sensitivity to
interest rate changes.
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Calculation of the Change in a Security’s Price Using the Duration versus the Time Value
of Money Formula
 To see the importance of accounting for the effects of convexity in assessing the impact of large interest rate changes, consider
the four-year, $1,000 face value bond with a 10 percent coupon paid semiannually and an 8 percent rate of return. In slide no
38, 39 and 41, we found this bond has a duration of 3.42 years, and its current price is $1,067.34. We represent this as point A
in the below figure. If rates rise from 8 percent to 10 percent, the duration model predicts that the bond price will fall by 6.577
percent; that is:

 or from a price of $1,067.34 to $997.14 (see point B in the below figure).

However, calculating the exact change in the bond’s price after a rise in rates
to 10 percent, we find its true value is:

 This is point C in the figure. As we can see, the true or actual fall in price is less than the predicted fall by $2.86. The reason for
this is the natural convexity to the price-rate curve as interest rates rise.
 Reversing the experiment reveals that the duration model would predict the bond’s price to rise by 6.577 percent if yields fell
from 8 percent to 6 percent, resulting in a predicted price of $1,137.54 (see point D in right hand side figure). By comparison,
the true or actual change in price can be computed as $1,140.39 by estimating the present value of the bond’s coupons and its
face value with a 6 percent rate of return (see point E in figure). The duration model has under predicted the bond price
increase by $2.85 ($1,140.39 - $1,137.54).
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Convexity & Characteristics of Convexity
Convexity (CX) measures the change in slope of the price-yield curve around
interest rate level R
Convexity incorporates the curvature of the price-yield curve into the estimated
percentage price change of a bond given an interest rate change.
Convexity is desirable. The greater the convexity of a security or portfolio of
securities, the more insurance or interest rate protection an investor or FI
manager has against rate increases and the greater the potential gains after
interest rate falls.
Convexity diminishes the error in duration as an investment criterion. The larger
the interest rate changes and the more convex a fixed-income security or
portfolio, the greater the error the investor or FI manager faces in using just
duration (and duration matching) to immunize exposure to interest rate shocks.
All fixed-income securities are convex. That is, as interest rates change, bond
prices change at a non-constant rate zero.
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