Duration measures a bond's sensitivity to interest rate changes, directly representing its interest rate risk. A higher duration indicates greater price volatility when rates move, while a lower duration signifies less sensitivity. Generally, a 1-year increase in duration results in a 1% price drop if rates rise by 1%, and vice versa.
Generally, when interest rates rise, the higher a bond's duration is, the more its price will fall. Time to maturity and a bond's coupon rate are two factors that affect a bond's duration. A fixed-income portfolio's duration is computed as the weighted average of individual bond durations held in the portfolio.
That's not to be confused with a bond's maturity, which is simply the date on which a bond issuer must repay the principal of a bond to the bond holder in full. Generally, the higher the duration, the more sensitive your bond investment will be to changes in interest rates.
Duration is a measurement of a bond's interest rate risk that considers a bond's maturity, yield, coupon and call features. These many factors are calculated into one number that measures how sensitive a bond's value may be to interest rate changes.
Duration assumes a linear relationship between bond prices and changes in interest rates. In actuality, however, prices fall at an increasing rate as interest rates rise; similarly, prices rise at an increasing rate as interest rates fall.
A higher duration implies greater price volatility should rates move. Duration is quoted as the percentage change in price for each given percent change in interest rates. For example, the price of a bond with a duration of 2 would be expected to increase (decline) by about 2.00% for each 1.00% move down (up) in rates.
Bottom line. Long-term bonds and some corporate bonds may become more attractive if interest rates continue to fall. As market demand shifts from shorter-term bonds to longer-term debt instruments, the key is maintaining a diversified portfolio.
Duration matching is a risk management strategy, commonly used in the insurance industry, where the duration (price sensitivity to a yield curve movement) of an asset portfolio is adjusted to be made equal to the duration of the liability. This is done under that assumption that doing so eliminates interest risk.
Duration refers to the price sensitivity of a bond, or a portfolio of bonds, to a change in interest rates. It is measured in years. The higher the duration, the greater the responsiveness of the bond price – or the value of a bond portfolio – to a change in interest rates.
There are four types of structural interest rate risk. As defined in the Basel paper, the four risks are repricing (mismatch), yield curve, basis and optionality. Repricing or mismatch risk is created when fixed rate loans are funded by variable rate borrowings or when fixed rate deposits fund variable rate loans.
How investors use duration. Generally, the higher a bond's duration, the more its value will fall as interest rates rise, because when rates go up, bond values fall and vice versa.
Recall that modified duration illustrates the effect of a 100-basis point (1%) change in interest rates on the price of a bond. Therefore, If interest rates increase by 1%, the price of the 5-year bond will decrease by 4.22%. If interest rates decrease by 1%, the price of the 5-year bond will increase by 4.22%.
There are three types of bond durations namely, Macaulay duration, modified duration and effective duration. A Macaulay duration represents the weighted average time before a bond's cash flows are fully paid and provides an effective way of measuring the time until an investor will get their money back.
Basic compound interest
For other compounding frequencies (such as monthly, weekly, or daily), prospective depositors should refer to the formula below. Hence, if a two-year savings account containing $1,000 pays a 6% interest rate compounded daily, it will grow to $1,127.49 at the end of two years.
Interest rates can also be fixed or variable. Variable interest rates can change over the length of the loan depending on market conditions, meaning if you take out a loan, your payment may increase or decrease at different times. Fixed interest rates are locked in for the length of a loan and cannot change.
Duration indicates the interest rate risk inherent in a bond investment. Bonds with higher durations involve more risk, as their prices will fluctuate more widely with interest rate shifts.
Generally speaking, duration tells us the degree of interest rate risk of a particular income investment. The higher the duration, the more an investment's price will drop as interest rates increase (or increase as interest rates decrease).
Long-term bonds are more sensitive to interest rate changes than short-term bonds because of their longer duration. Since bond prices move inversely to interest rates, long-term bonds gain more when rates fall and lose more when they rise.
Rising yields can create capital losses in the short term, but can set the stage for higher future returns. When interest rates are rising, you can purchase new bonds at higher yields. Over time the portfolio earns more income than it would have if interest rates had remained lower.
The duration gap measures the mismatch between the repricing timing of cash inflows (assets) and cash outflows (liabilities) of instruments which are already on banks' balance sheet. A positive duration gap indicates that the duration of assets is larger than the duration of liabilities.
Diversification. By diversifying across different bond types and sectors, investors can mitigate duration risk.
Warren Buffett views bonds as a safe haven for cash, often recommending a 90/10 portfolio (90% S&P 500 index fund, 10% short-term government bonds) for average investors, while Berkshire Hathaway itself holds large amounts of U.S. Treasury bills for capital preservation and to earn competitive yields, especially when stocks are expensive. He favors short-term Treasuries (T-bills) due to low interest rate risk and high liquidity, using them to park cash while waiting for better stock opportunities, rather than as a primary growth engine.