What is duration of bonds? Why is it important?

Expert Solution

Duration is one of the most important concepts in finance when it comes to fixed income securities. In simple words duration can be understood as a measure of sensitivity of bond's price with changes in interest rate. It is the time weighted average cash flow received from bonds which implies that it is measured in years and is calculated by dividing the present value of (period*cash flows) by the current market price of the bond.

To clear the concept with an example - let us assume that the duration of a bond is 5 years, it would mean that the price of the bond will change by 5% for every 1% change in the interest rate. The change shall be in the opposite direction since price of bond and interest rates have an inverse relationship. Increase of 1% in interest rate would result in 5% decrease in the price of bond.

The importance of duration lies in the fact that it gives the investors the idea of how will his particular bond behave to a particular change in interest rate i.e. lets say that the duration of the benchmark bond is 8 years and the duration of an investor's particular bond is 5 years. It would mean that the benchmark is more sensitive to the interest rates and during the time that the interest rates are decreasing, the benchmark will outperform the investor's bond (due to the inverse relationship between bond price and interest rate and because of the fact that benchmark is more volatile and reactive to change in interest rate). Similarly when the interest rates are increasing, the benchmark bond's price will fall drastically as compared to the investor's bond.

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What is duration of bond? Why is it important?

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