Duration
Duration is a measure in years of how long it takes for the price of a bond to be repaid by its cash flows. Bonds with lower coupon rates and longer maturities will have higher durations, because it takes more time for investors to earn back the money they invested. Zero coupon bonds don’t pay any cash flows until maturity, so they have the highest durations, and their durations are always equal to the length of maturity.
Conceptually, duration measures how sensitive a bond’s price is to changes in interest rates. The prices of bonds with higher durations are more sensitive to interest rate changes than the prices of bonds with lower durations. To understand this, start by thinking about how much money a bond is paying out in total. Some of the money will be paid at maturity and some will be paid in interest along the bond’s life. With respect to interest rate risk, the more money you receive in interest payments early on, the better, because once a payment is made, the money is no longer subject to interest rate risk. If most of your money is received at the end of the bond’s life, as in zero coupon bonds, it is subject to a lot of interest rate risk, so the duration is higher.
Duration can be used to calculate how a bond’s price will change with a change in interest rates. A duration of 12 means that a 1% change in interest rates will result in about a 12% change in price. Since price and interest rates have an inverse relationship, a 1% decrease in interest rates will result in a 12% increase in price, and a 1% increase in interest rates will result in a 12% decrease in price.
Example Question 1
Bond X has a duration of 10. Bond Y has a duration of 8. Which of the following are true?
- I. If interest rates fall by