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We also know that longer maturity debt securities tend to be more volatile in price.
For a given change in interest rates, the price of a longer term bond generally changes more than the price of a shorter term bond.
Duration: Introduction
Knowledge of the impact of varying coupon rates on security price volatility led to the development of a new index of maturity other than straight calendar time. The new measure permits analysts to construct a linear relationship between term to maturity and security price volatility, regardless of differing coupon rates.
Duration
Present value of interest and principal payments from a security weighted by the timing of those payments D= Present value of the securitys promised stream of interest and principal payments =
t CPt t S (1 + i) t=1
CPt S (1 + i)t t=1
n
Duration
CP represents the expected payment of principal and interest income. t represents the time period in which each payment is to be D = received. And i is the securitys yield to maturity.
t CPt t S (1 + i) t=1
CPt S (1 + i)t t=1
n
Duration Example
Assume there is an investor who is interested in buying a $1,000 par value bond that has a term to maturity of 10 years, a 10 percent annual coupon rate, and a 10 percent yield to maturity based on its current price. $100(1) $100(2) ... $100(10) $1000(10) + + + + (1.10) (1.10)2 (1.10)10 (1.10)10 $100 $100 $100 $1000 + + ... + + (1.10) (1.10)2 (1.10)10 (1.10)10
D =
= 6758.9 1000
6.758 years
1 2 3 4 5 6 7 8 9 10 10 Total
100 100 100 100 100 100 100 100 100 100 1000
90.01 82.64 75.13 68.30 62.09 56.44 51.32 46.65 42.41 38.55 385.54 1000.00
0.09001 0.08264 0.07513 0.06830 0.06209 0.0.644 0.05132 0.04665 0.04241 0.03855 0.38554 1.00
0.09091 0.16528 0.22539 0.27320 0.31045 0.33864 0.35924 0.37320 0.38550 0.38550 3.85500 6.75850
1 2 3 4 5 6 7 8 9 10 10 Total
100 100 100 100 100 100 100 100 100 100 1000
83.33 69.44 57.87 48.23 40.19 33.49 27.91 23.26 19.38 16.15 161.15 580.76
0.14348 0.11957 0.09650 0.08305 0.06920 0.05767 0.04806 0.04005 0.03337 0.02781 0.27808 1.00
0.14348 0.23914 0.29895 0.33220 0.34600 0.34602 0.33642 0.32040 0.30033 0.27810 2.78100 5.72204
Things to Notice
When the yield to maturity rises, the duration of the coupon bond falls. The higher the coupon rate on the bond, the shorter the duration of the bond. When the maturity of a bond lengthens, the duration rises as well. Duration is additive: the duration of a portfolio of securities is the weighted-average of the durations of the individual securities, with the weights equaling the proportion of the portfolio invested in each.
Duration is Additive
The duration of a portfolio of securities is the weighted average of the durations of the individual securities with the weights reflecting the proportion invested in each.
Example: Let 25% of a portfolio be invested in a bond with a duration of 5 and let 75% of the portfolio be invested in a bond with a duration of 10.
Dp = (0.25 x 5) + (0.75 x 10) = 8.75 years
D = duration /\ i = change in interest rates % Change in the price of a debt security 0.02 x 100% = -11.91% = -6.55 x 1 + 0.10
An increase in interest rates of 2% causes a decline in the bonds price of approximately 12%.