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What is the effective duration of a bond?
Effective duration is the sensitivity of the price of a bond against the benchmark yield curve. One can assess the risk of a bond by estimating the percentage change in the price of the bond against the benchmark yield curve.
Effective duration is used for hybrid securities like a bond that has an embedded option (callable option). Such hybrid securities have very uncertain cash flows. It is difficult to know the rate of return from such bonds. Hence it is important to assess the risk of such bonds. Effective duration measures the impact on cashflows due to interest rate changes. In other words, it helps in calculating the expected cash flows from the bond by calculating the volatility of interest rates in relation to the yield curve.
Effective duration estimates the decline in the price of the bond due to the increase in interest rate by 1%. The value of the effective duration is always lower than the maturity value of the bond. Effective duration has four important variables in its formula. They are the original price of the bond, the price of the bond if the yield were to decrease by a certain percentage, the price of the bond if the yield were to increase by a certain percentage and the estimated change in the yield.
The formula for Effective Duration
Effective duration = (P(1) – P(2)) / (2 *P(0) * Y)
Where,
P(0) = Original price of the bond
P(1) = the price of the bond if the yield decreases by Y%
P(2) = the price of the bond if the yield increases by Y%
Y = Estimated change in the yield.
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Why is Bond duration important?
Bond duration measures the interest rate risk. In other words, it is a measure of the change in bond prices due to a change in interest rate. Duration is measured in years. The higher the duration of the bond, the more will be the price drop as interest rates increase. This is because one needs to wait longer to get their coupon payments and principal amount back.
It is important to understand bond duration as it helps investors to determine how their investment in a bond will affect their portfolio. An understanding of bond duration is important for investors who want to sell their bond investments before maturity.
Bond duration is important to investors as it helps in measuring the sensitivity of a bond’s price to interest rates. If the interest rates were to fall by 1% and bond duration is three years, then the price will increase by 3%. This knowledge will help investors understand the effect on interest rate changes on the portfolio returns.
Bond duration helps in comparison of multiple bonds and selecting the one most suitable to an investor’s portfolio. For example, if the interest rates are expected to fall, then one can invest in long-duration bonds. And in uncertain market conditions, one can choose to invest in bonds that are less affected by market movements.
Read More: Definition of Zero Coupon Bond
What is duration risk?
Duration risk is the interest rate risk that comes along with the duration. In other words, it is how the change in interest rate would affect the market value of the investment. Simply put, duration risk is the sensitivity of a bond’s price to one per cent change in interest rate. Therefore, longer the duration, greater is the sensitivity to interest rate changes. The price fluctuations, whether positive or negative, is more pronounced.
However, low duration doesn’t mean low risk or risk-free. In addition to duration risk, bonds and bond funds are subject to inflation risk, default risk and call risk.
During the tenure of a bond, the interest rates in the market are not the same. In a rising interest rate regime, the value of the bonds fall. It is because, as the interest rates rise, the opportunity cost for the investor for holding the bond increases. Also, the investor might get a higher interest rate for the same value of the bond. Therefore to compensate that, the bond prices fall.
When the interest rates fall, investors automatically switch to bonds that pay a higher interest rate. Hence the price of the existing bonds fall. Therefore, investors may face trouble in selling low-value bonds against the more attractive ones in the market. Additionally, the market value of the bonds may go below the initial purchase price, leading to losses for the investor.
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What is the difference between duration and maturity?
Maturity of a bond is the date on which the bond becomes due for payment. It is the date on which the bond issuers repay the principal to the investor. The maturity date of a bond is set at the time of issue and doesn’t usually change. The time to maturity is the amount of time from now until the date of maturity. Also, the time to maturity reduces as the maturity date approaches. Interest rate changes don’t have an impact on maturity and time to maturity.
Duration, on the other hand, is the measure of the sensitivity of a bond’s price to interest rate changes. A bond’s duration is also in years. As the maturity date is approaching, the bond duration also reduces. The bond duration is either equal to or less than maturity. Duration is not just about time. It indicates the price change in a bond due to interest rate changes. Higher the duration, riskier is the bond.
The only thing common between duration and time to maturity is that both are measured in years. Also, as the date of maturity keeps approaching doth decline.
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What is the interest rate duration?
It is a measurement for the price sensitivity to the changes in the interest rate. Often, a bond’s duration is confused with its time to maturity or term, as both are measured in years. Bond’s term is a linear measure of the years until its repayment of principal. On the other hand, the duration is non-linear and also accelerates as time to maturity decreases.
Duration measures how long it takes in years for an investor to be repaid by the bond’s total cash flows. The duration can be:
Macaulay duration: It is the weighted average time until all the cash flows of the bond are paid. It accounts for the present value of future bond payments. Macaulay duration allows an investor to evaluate and compare bonds independent of their time to maturity or term.
Modified duration: Modified duration measures the expected change in the bond’s price for a 1% change in interest rate. The bond prices are inversely related to interest rates. Hence, with rising interest rates, the bond prices are likely to fall. Similarly, in a falling interest rate scenario, the bond prices are likely to increase.
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