Duration - Full Explanation & Example | InvestingAnswers
Duration is a measure of a bond's sensitivity to interest rate changes. The formula is complicated, but what it boils down to is: Duration = Present value of a . Duration indicates the years it takes to receive a bond's true cost, prices are said to have an inverse relationship with interest rates. This is true because, by definition, the current price of a bond is the present value of all its cash flows. . The dollar duration, or DV01 of a bond is a way to analyze the. little choice in defining the DV01 or duration. When we turn to valuation . The relation between DV01 and modified duration is: (5). ModD.
If rates rise and you sell your bond prior to its maturity date the date on which your investment principal is scheduled to be returned to youyou could end up receiving less than what you paid for your bond. Similarly, if you own a bond fund or bond exchange-traded fund ETFits net asset value will decline if interest rates rise.
The degree to which values will fluctuate depends on several factors, including the maturity date and coupon rate on the bond or the bonds held by the fund or ETF.
Using a bond's duration to gauge interest rate risk While no one can predict the future direction of interest rates, examining the "duration" of each bond, bond fund, or bond ETF you own provides a good estimate of how sensitive your fixed income holdings are to a potential change in interest rates.
Duration: Understanding the relationship between bond prices and interest rates
Investment professionals rely on duration because it rolls up several bond characteristics such as maturity date, coupon payments, etc.
Duration is expressed in terms of years, but it is not the same thing as a bond's maturity date. That said, the maturity date of a bond is one of the key components in figuring duration, as is the bond's coupon rate.
In the case of a zero-coupon bond, the bond's remaining time to its maturity date is equal to its duration.
Duration: Understanding the Relationship Between Bond Prices and Interest Rates - Fidelity
When a coupon is added to the bond, however, the bond's duration number will always be less than the maturity date. The larger the coupon, the shorter the duration number becomes. Generally, bonds with long maturities and low coupons have the longest durations. These bonds are more sensitive to a change in market interest rates and thus are more volatile in a changing rate environment.
Conversely, bonds with shorter maturity dates or higher coupons will have shorter durations. Bonds with shorter durations are less sensitive to changing rates and thus are less volatile in a changing rate environment.
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Why is this so? Because bonds with shorter maturities return investors' principal more quickly than long-term bonds do. Therefore, they carry less long-term risk because the principal is returned, and can be reinvested, earlier.
Difference between DV01 and Duration
This hypothetical example is an approximation that ignores the impact of convexity; we assume the duration for the 6-month bonds and year bonds in this example to be 0. Duration measures the percentage change in price with respect to a change in yield.
FMRCo Of course, duration works both ways. If interest rates were to fall, the value of a bond with a longer duration would rise more than a bond with a shorter duration. Using a bond's convexity to gauge interest rate risk Keep in mind that while duration may provide a good estimate of the potential price impact of small and sudden changes in interest rates, it may be less effective for assessing the impact of large changes in rates.
This is because the relationship between bond prices and bond yields is not linear but convex—it follows the line "Yield 2" in the diagram below. Thus, the formula is less reliable when there is a large change in yield. In general, six things affect a bond's duration: The higher a bond's coupon, the more income it produces early on and thus the shorter its duration.
Difference between DV01 and Duration | Bionic Turtle
The lower the coupon, the longer the duration and volatility. Zero-coupon bonds, which have only one cash flowhave durations equal to their maturities. The longer a bond's maturity, the greater its duration and volatility. Duration changes every time a bond makes a coupon payment.
Over time, it shortens as the bond nears maturity. The higher a bond's yield to maturity, the shorter its duration because the present value of the distant cash flows which have the heaviest weighting become overshadowed by the value of the nearer payments.
The presence of a sinking fund lowers a bond's duration because the extra cash flows in the early years are greater than those of a bond without a sinking fund. Bonds with call provisions also have shorter durations because the principal is repaid earlier than a similar non-callable bond.