Question

Explain the concept of duration.

Why is duration is thought of as a measure of risk?

If duration is a measure of risk, what would you do if interest rates are expected to rise (assume you want to be fully invested in bonds). Would you buy bonds with shorter or longer durations?

Answer 1

The "duration" bond is defined as the expected change in the price of the bond when there is an interest rate hike. In other words, it is the sensitivity of the bond price with respect to a unit change in the market interest rates.

Duration is thought of a measure of risk since it depicts how much the price of the bond falls or rises when the interest rates move. We know that there is an inverse relationship between bond prices and interest rates. Hence as interest rates rise, bond price falls. So, if a bond has a duration of 5 years, it means the bond price will fall 5% for a percentage rise in market interest rate and if a bond has a duration of 2 years, it means the bond price will fall 2% for a percentage rise in market interest rate. Hence we can describe risk as "higher the duration, the greater the risk".

If the interest rates are expected to rise, then it would be better to have "SHORTER" duration bonds since the price fall will be lower.