Question

The text discusses 6 features and the impact of the duration (Pp. 516-518) of a bond that affects the sensitivity of its price. Select and analyze one feature or discuss how duration impacts the sensitivity of a bond. Consider these questions in your answer and reply to your classmates: Why is the feature a concern? What does this mean for investors? Can investors avoid this feature, why or why not?

Answer 1

Duration and convexity are two tools used to manage the risk exposure of fixed-income investments. Duration measures the bond's sensitivity to interest rate changes. With coupon bonds, investors rely on a metric known as duration to measure a bond's price sensitivity to changes in interest rates. Because a coupon bond makes a series of payments over its lifetime, fixed-income investors need ways to measure the average maturity of a bond's promised cash flow, to serve as a summary statistic of the bond’s effective maturity.

Generally, the longer the maturity of the asset, the more sensitive the asset to changes in interest rates. Changes in interest rates are watched closely by bond and fixed-income traders, as the resulting price fluctuations affect the overall yield of the securities. There are four widely used duration measurements to determine a fixed-income security's interest-rate sensitivity—the Macaulay duration, modified duration, effective duration, and key rate duration.

Unfortunately, duration has limitations when used as a measure of interest rate sensitivity. While the statistic calculates a linear relationship between price and yield changes in bonds, in reality, the relationship between the changes in price and yield is convex.Convexity, a measure of the curvature of the changes in the price of a bond, in relation to changes in interest rates, addresses this error, by measuring the change in duration, as interest rates fluctuate.

Ever-changing interest rates introduce uncertainty in fixed-income investing. Duration and convexity let investors quantify this uncertainty, helping them manage their fixed-income portfolios.