Now, the bottom line of the bottom line. An example of this would be a movie with perhaps a duration of two hours or a roller coaster with a duration of one and a half minutes. Bond Basics A basic bond is issued with a face value, coupon and maturity. The formula to calculate the percentage change in the price of the bond is the change in yield multiplied by the negative value of the modified duration multiplied by 100%. Modified duration follows the concept that interest rates and bond prices move in opposite directions. This sometimes leads into confusion. However, they mean very different things.
Sometimes we can be misled into thinking that it measures which part of the yield curve the instrument is sensitive to. Macaulay duration, modified duration and effective duration are three types of duration calculations. Get Started: To search for a security, type the name or ticker in the search box at the top of the page and select from the dropdown results. On the other hand, a bond with call features - i. Website: Founded in 1996 by a group of portfolio managers, The Financial Pipeline is dedicated to providing financial knowledge and education to anyone and everyone with even a passing interest in Finance.
Durations are also very important factors in determining yields on prices and other percentages in the field of finance. For example, a 5-year fixed-rate interest only bond would have a Weighted Average Life of 5, and a Macaulay Duration that should be very close. Effective duration is another, still-more complicated measure used to assess interest-rate sensitivity when callable securities those that may be paid off before maturity are involved. Occasionally, a simulated average life may be computed from multiple cash-flow scenarios, such as those from an model. Calculated as: Modified duration measures the average cash-weighted of a bond. However, modified duration is still a good indication of the potential price of a bond.
Recall that the formula s for duration measured how long it took for the cash flows to repay the initial investment. Modified duration is a better measure for bonds that do not have imbedded options than Macauley because it factors in that duration is sensitive to changes in interest rates. Complexity increases in the details of various ways duration is calculated. The modified duration of the receiving leg of a swap is calculated as nine years and the modified duration of the paying leg is calculated as five years. Duration is a financial term referring to the cash flow of finances. A bond's duration, on the other hand, is a more abstract concept often used to measure interest-rate sensitivity. It provides a measure of a bond's interest rate risk that complements other risk criteria, such as credit and liquidity risk.
Macaulay duration is useful in immunization, where a portfolio of bonds is constructed to fund a known liability. Good luck in your studies. For example, if we think about pricing a bond against an upward sloping term structure where each bond cash flow is discounted at the appropriate zero spot rate , the we can refer generically to the dollar value in change of bond price if we shift the entire term structure down by 1 bps so that each cash flow is discounted by: previous zero rate - 1 bps. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Measuring the Effect of an Interest-Rate Change Investors can use duration to help estimate how a bond or bond fund's value would be affected by a change in interest rates. Keep in mind the image of a see-saw on a playground conveying the idea that when interest rates go up, bond prices go down and the opposite is true.
You have been redirected here from Hemscott. For example, an asset management firm that is bullish on bonds, meaning that it believes interest rates will fall, can maximize gains for its investors by constructing a high duration portfolio. On the other hand, Modified Duration is about the percentage change in price for a unit change in yield, it also refers to the price sensitivity. Again, yield is inverse to price. Copyright © Zacks Investment Research At the center of everything we do is a strong commitment to independent research and sharing its profitable discoveries with investors.
Longer-duration bonds and bond funds also typically have higher yields than their shorter-term counterparts to compensate investors for taking on added interest-rate risk. Duration or Macaulay Duration refers to measurement of weighted average time before having the cash flow, while Modified Duration is more on the percentage change in price in terms of yields. A 30-year Treasury Bond, as the name implies, matures or pays back its face value 30 years from its initial date. Macaulay duration has the diagrammatic interpretation shown in figure 1. These durations will be able to give you the right decisions while following your intuition. This aspect of relationship of bond prices to changes in interest rates is not captured by duration and as such duration underestimates the actual price of a bond for a given rate change. This is what creates confusion, and hence to solve this problem there are two terms, namely Duration Macaulay Duration , and Modified Duration.
Similarly, if you are a Hemscott Premium user, you now have a Morningstar Premium account which you can access using the same login details. Key rate durations might be defined, for example, with respect to zero-coupon rates with maturity '1M', '3M', '6M', '1Y', '2Y', '3Y', '5Y', '7Y', '10Y', '15Y', '20Y', '25Y', '30Y'. Modified duration is a rate of change, the percent change in price per change in yield. It's important to note that bond prices and interest rates have an with each other. The formula for the modified duration is the value of the Macaulay duration divided by 1, plus the yield to maturity, divided by the number of coupon periods per year. Weighted Average Life does not discount.