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DurationofBonds
FiledUnder:AdvanceInvestingbyDanielGuidotti

TableofContents
Chapter1:CategoriesofBonds
Chapter2:PricingofBonds
Chapter3:CalculatingYieldandUnderstandingYieldCurve
Chapter4:DurationofBonds
Chapter5:RelationshipBetweenPrice,YieldandDuration
NavigateThisPage
Chapter4:DurationofBonds
FactorsthatAffectDuration
DurationoftheTwoBasicBondTypes
ZeroCouponBond
VanillaBond
TypesofDuration
MacaulayDuration
ModifiedDuration
EffectiveDuration
KeyRateDuration
Chapter4:DurationofBonds
Durationofabondisameasureoftenusedtoassesstheriskinvolvedwiththebondinstrument.Itisthe
effectivedurationinyearsormaturitytime,inwhichthebondpriceisrepaidbytheinternalcashflows.
Thegreatertheduration,themoreisthesensitivitytointerestratechanges,whichinturnmeanshigher
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riskwiththeinstrument.Thismeasureisveryusefulincomparingtheinterestraterisksofvarious
securities.
Durationismanytimesunderstoodasthe%changeinthepriceofthebondforaunitpercentchangein
yieldtomaturity.Thedurationcanbeapproximatedusingthefollowingformula:
Durationofbond=(BondPricewheninterestrateincreasesBondPricewheninterestratedecreases)/
(2xInitialBondPricexChangeininterestrate)
Durationofbondcanbevisualizedasaseesawwithafulcrumwhosepositionwhenchangedbalances
thepaymentspresentvaluesandthebondsprincipalpayment.
FactorsthatAffectDuration
Thedurationofabondchangesasthecouponpaymentskeepgettingmade.Ifwevisualizeaseesawwith
thelengthofplankequaltothematurityperiod,fulcrumplacedatthedurationofbondandmoneybags
representingrepaymentcashflowsplacedontheplankallthroughthelengthtothematuritytime,then
everycouponpaymentistakeofftheplankastheygetpaid,causingthefulcrum(duration)tomove
forwardatfuturepointintime(representingthenewdurationofbond).
Thedurationvaluekeepsonchangingthroughoutthebondperiod.However,thevalueofdurationin
years,keepdecreasingwiththeprogresstowardsthematuritydate.Italsoincreasesmomentarilyonthe
dateofcouponpayment.Thedurationvaluekeepsvaryinginthisfashiontilliteventuallybecomeszero
andmergeswiththematurityofthebond.
Otherfactorsthataffectthebonddurationarethebondsyieldandcouponrate.Bondsthathavehigh
couponrates,whichinturnmeanshighyields,usuallyhavesmallerdurationsthantheviceversacase.A
highercouponrateoryieldmeansthatthebondholderisreceivingtheinvestedmoneyatafasterrate,
whichisindicatedbylowerdurationsandhence,lowerperceivedrisks.
DurationoftheTwoBasicBondTypes
ZeroCouponBond:Forazerocouponbond,durationisthesameasitsmaturityperiod.Fora
zerocouponbond,thefulcrumontheseesawwouldbeplacedrightunderthebondsfuturevalue
moneybagatthematurityperiod(rightmostendoftheplank),balancingitsloadrightunder.This
isbecausethecompletecashflowforazerocouponbondcomesthroughatthetimeofmaturity.
VanillaBond:Foravanillabond,thedurationofbondislessthanthematuritytime.Ifwenow
againvisualizetheseesaw,theninthecaseofvanillabond,themoneybagswouldbeplacedall
overtheplank.Smallermoneybagsrepresentingsmallerrepayments/cashflowsbeforethe
maturitytime(rightmostendofplank)andabiggermoneybagplacedattherightmostend
indicatingthelastbigpaymentattheendofbondmaturity.
Thefulcruminthiscasewillbepositionedsomewherebetweentheinitialandfinalpointoftime
(beginningandendofbondperiod).Thefulcrumbalancestheplankatthepointintimewhenthe
totalcashflowtillthattimeequalsthebondprice.
TypesofDuration
Calculationofdurationcanbedoneinmorethanoneways,eachgivingrisetoaslightlydifferenttypeof
duration.Thesetypesdifferinthewaytheyaccountforthechangesininterestrateandredemption
featuresandembeddedbondoptions.Fourkeytypesofdurationarediscussedhere:
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MacaulayDuration
Thisisthemostcommonwayofcalculatingabondsdurationanditbecamepopularstarting
1970s.ThisdurationderivesitsnamefromitscreatorFrederickMacaulay.Thisdurationis
calculatedasthesumofmultiplicationsofcashflowpresentvaluesandcorrespondingtimein
whichtheyarepaid,dividedbythebondstotalprice.
Theformulaofthisdurationis:
Macaulayduration=[(t=1ton){(txC)/(1+Yi)^n+(nxPar)/(1+Yi)^n}]/BondPrice
WhereYiistherequiredyield,Paristhematurity(par)value,Ciscashflow,tisthebondsmaturity
timeandnistheno.ofcashflows.
ModifiedDuration
ThisisamodifiedversionofMacaulaydurationandtakesintoaccounttheinterestratechanges.
Changesininterestratesaffectdurationastheyieldgetsaffectedeachtimetheinterestratevaries.
Inregularbonds,theinterestratesandbondpricemoveinoppositedirections.Anapproximate
unitpercentchangeinyieldsharesaninverserelationshipwithmodifiedduration.Thistypeof
durationisverywellsuitedforthepurposeofgaugingaparticularbondsvolatility.
Theformulaformodifieddurationisasfollows:
Modifiedduration=MacaulayDuration/(1+(yieldtomaturity/no.ofcouponperiodsperyear))
EffectiveDuration
Inaboveformula,cashflowsareconsideredtobeconstant.However,incaseofbondswith
redemptionfeaturesandembeddedbondoptions,cashflowsalsochangeastherateofinterest
changes.Forsuchbonds,thedurationcalculationhastotakeintoaccountthisvariability.Effective
durationdoesjustthat.Itusesbinomialtreestoestimatetheoptionadjustedspread.These
calculationscangetabitcomplex.
KeyRateDuration
Keyratedurationcalculatestheelevenkeymaturitiesspotdurations.Thesematuritiesare
positionedat3months,1year,2years,3years,5years,7years,10years,15years,20years,25
yearsand30yearsonthespotratecurve.
Thekeyratedurationallowsportfoliodurationtobecalculatedforachangeequivalentto1basis
pointinrateofinterest,whilekeepingtheyieldformaturitiesotherthanthoseonthe11points
constant.Thisdurationismostcommonlyusedforportfolios,whichcompriseofsecuritieswith
differingmaturityperiods.Itshouldbenotedthatadditionofthevariouskeyratedurationsalong
thespotratecurveisthesameascalculatingeffectiveduration.
Theformulaforkeyratedurationis:
{Bondpriceafteryielddecreaseof1%Bondpriceafteryieldincreaseof1%}/{2xInitialbondprice
x1%}
Chapter5:RelationshipBetweenPrice,YieldandDuration

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Recommendedforyou:
1. BondPrice,YieldandDuration
2. ModifiedDuration
3. MacaulayDuration
4. PricingofBonds
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