Financial Markets and Institutions

CHAPTER III – DURATION

Financial Markets and Institutions

CHAPTER III – DURATION
 DURATION
It also has
economic meaning Duration
as the sensitivity, or describes the
elasticity , of percentage price,
On a time value of that asset or or present value,
It is the weighted - money basis, liability’s value to change of a
average time to duration measures small interest rate financial security
maturity on a the weighted changes (either for a given (small)
financial security average of when required rate of change in interest
using the relative cash flows are return or yield to rates.
present values of received on a maturity).
the cash flows as security
weights.
ELASTICITY is the
percentage change
in the price of a
bond for a given
change in interest
rates.
 A Simple Illustration of Duration
Consider a bond with one year remaining to
maturity, a $1,000 face value, an 8 percent Figure 3–4
coupon rate (paid semi annually), and an interest Promised Cash Flows on the One- Year Bond
rate (either required rate of return or yield to
maturity) of 10 percent. The promised cash flows
from this bond are illustrated in Figure 3–4 . The
bond holder receives the promised cash flows
(CF) from the bond issuer at the end of one-half
year and at the end of one year.

CF½ is the $40 promised payment of (semi annual) coupon interest ($1,000 X 8% X ½) received
after six months. CF1 is the promised cash flow at the end of year 1; it is equal to the second
$40 promised (semi annual) coupon payment plus the $1,000 promised payment of face value.
 To compare the relative sizes of these
two cash flow payments—since duration Figure 3–5
measures the weighted-average time to Present Value of the Cash Flows from the Bond
maturity of a bond—we should put them in
the same dimensions, because $1 of
principal or interest received at the end of
one year is worth less to an investor in
terms of time value of money than is $1 of
principal or interest received at the end of Note that since CF1/2, the cash flow received at the end
six months. Assuming that the current of one-half year, is received earlier, it is discounted at (1+R/2)
interest rate is 10 percent per year, we (where R is the current annual interest rate on the bond);
calculate the present values ( PV ) of the this discount factor is smaller than the discount rate applied
two cash flows ( CF ) as: to the cash flow received at the end of the year (1+R/2) 2 .

CF1/2
1/2
= $40 PV1/2
1/2
= $40/(1.05) = $38.10 Figure 3–5 summarizes the PVs of
the cash flows from the bond.
CF11 = $1,040 PV11 = $1,040/(1.05)22 = $943.31

PV1/2
1/2
+ PV11 = $981.41
 Time (t) Weight (X)

1/2 year X1/2

1 year X1

1.0 100%

In present value terms, the bond holder We can now calculate the duration ( D ), or
receives 3.88% of the cash flows on the bond the weighted-average time to maturity of
with the first coupon payment at the end of six the bond, using the present value of its cash
months (t1/2) and 96.12% with the second flows as weights:
payment of coupon plus face value at the end
of the year (t1) . By definition, the sum of the DLL = X1/2
1/2
x (t1/2
1/2
) + X11 x (t11)
(present value) cash flow weights must equal 1: = .0388 x (1/2) + .9612 x (1) = .9806 years

X1/2
1/2
+ X11 = 1
0.388 + 0.9612 = 1
 A General Formula for Duration
You can calculate the duration for any fixed-income security that pays
interest annually using the following formula:

where
D = Duration measured in years
t = 1 to T, the period in which a
cash flow is received For bonds that pay interest
N = Number of periods to maturity semi annually, the duration
CFt = Cash flow received on the equation becomes:
security at end of period t
r = Current required rate of return (r)
or yield to maturity (ytm) on the
investment
PVt = Present value of the cash flow
received at the end of the period
Features of Duration
It provides several important
features of duration relating to the
time remaining to maturity, yield to
maturity, and coupon interest of the
underlying bond being analyzed.
Duration
Duration and Rate of Return
It indicates that duration decreases
as rate of return increases.
Duration and Coupon Interest.
It indicates that the higher the
coupon or promised interest
payment on the bond, the
shorter its duration.
Duration and Maturity
It indicates that duration
increases with the maturity of a
bond, but at a decreasing rate.
In addition to being a measure of the average life
of a bond, duration is also a direct measure of its Economic Meaning
interest rate sensitivity, or elasticity.
The specific relationship between the factors for
of Duration
securities with annual compounding of interest is
For securities with semi annual receipt
represented as:
(compounding) of interest, it is represented as:

The economic interpretation of this equation is that the number D is the interest elasticity. The
negative sign in front of the D indicates the inverse relationship between interest rate changes and
price changes. That is, –D describes the percentage fair or current value decrease—capital loss—on
the security () for any given (discounted) small increase in interest rates (/(1+)), where is the change in
interest rates and 1+ is 1 plus the current (or beginning) level of interest rates.
 where where

The definition of duration can be rearranged in The duration equation can be rearranged, combining
another useful way for interpretation regarding D and (1+) into a single variable D /(1+) , to produce
interest sensitivity: what practitioners called modified duration ( MD) .

Annual compounding interest Annual compounding interest

Semi annual compounding interest Semi annual compounding interest

 CONVEXITY - The degree of curvature of
the price–interest rate curve around some
It needs to be stressed here that duration accurately interest rate level.
measures the price sensitivity of financial securities
only for small changes in interest rates of the order
of one or a few basis points (a basis point is equal to Convexity is desirable
one-hundredth of 1 percent).

However, that interest

rate shocks are much
larger, of the order of 2
Large Interest
Convexity diminishes the
percent or 200 basis
points or more.
Rate Changes error in duration as an
investment criterion.

Duration predicts that the and Duration

relationship between an
interest rate change and a All fixed-income securities are
security’s price change will convex.
be proportional to the
security’s D (duration).
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