[Solved] 1.What does duration tell you about the sensitivity of a bond... | CliffsNotes (2024)

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[Solved] 1.What does duration tell you about the sensitivity of a bond... | CliffsNotes? ›

Duration

Duration measures a bond price's sensitivity to changes in interest rates—so why is it called duration? A bond with a longer time to maturity will have a price that is more sensitive to interest rates and, thus, a larger duration than a short-term bond.

Bond duration is a fundamental concept in fixed-income investing. It measures the sensitivity of a bond's price to changes in interest rates by calculating the weighted average time it takes to receive all the interest and principal payments.

Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk.

Macaulay and modified duration measure the sensitivity of a bond's price to changes in the level of interest rates. Convexity measures the change in duration for small shifts in the yield curve, and thus measures the second-order price sensitivity of a bond.

Duration is an important measure of the interest rate risk of a bond or a portfolio of bonds, as it reflects the likely price volatility related to changes in interest rates. The higher the duration of an asset or a portfolio, the higher the interest rate risk and the higher the likely price volatility.

Sensitivity determines how an investment changes with fluctuations in outside factors. Stocks and bonds are especially sensitive to interest rate changes. The discount rate is an important factor in deriving the theoretical value of stocks.

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.

Answer and Explanation:

The duration of a bond depends on its coupon rate and yield to maturity. The present value of cash flows depends on the yield to maturity (i.e., discount rate) and coupon rate (which determines the amount of cash flows). A bond's Macaulay Duration is the present value weighted time to maturity.

While portfolio duration is expressed as a number of years, it really represents a measure of how sensitive a bond portfolio is to a given change in interest rates. Specifically, the value represents the change in value that we should expect if interest rates change 1%.

Why are longer bonds more sensitive? ›

When interest rates rise, bond prices fall (and vice-versa), with long-maturity bonds most sensitive to rate changes. This is because longer-term bonds have a greater duration than short-term bonds that are closer to maturity and have fewer coupon payments remaining.

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.

Duration measures the bond's sensitivity to interest rate changes. Convexity relates to the interaction between a bond's price and its yield as it experiences changes in interest rates. With coupon bonds, investors rely on a metric known as duration to measure a bond's price sensitivity to changes in interest rates.

Duration is a good measure of interest rate sensitivity because the calculation includes multiple bond characteristics, such as coupon payments and maturity. Generally, the longer the maturity of the asset, the more sensitive the asset to changes in interest rates.

The strength of a bond between two atoms increases as the number of electron pairs in the bond increases. Thus, we find that triple bonds are stronger and shorter than double bonds between the same two atoms; likewise, double bonds are stronger and shorter than single bonds between the same two atoms.

For example, sensitivity analysis can be used to study the effect of a change in interest rates on bond prices if the interest rates increased by 1%. The “What-If” question would be: “What would happen to the price of a bond If interest rates went up by 1%?”. This question can be answered with sensitivity analysis.

For example, if a portfolio has a duration of 4 years then if interest rates decrease by 1% we would expect the value of the portfolio to rise 4%. Importantly, the opposite is also true - If interest rates rise 1%, we would expect the value of the portfolio to decrease 4%.

A measure of a fund's interest-rate sensitivity—the longer a fund's duration, the more sensitive the fund is to shifts in interest rates.

Investment professionals rely on duration because it rolls up several bond characteristics (such as maturity date, coupon payments, etc.) into a single number that gives a good indication of how sensitive a bond's price is to interest rate changes.