duration

Definition

Duration is a financial metric used to measure the sensitivity of a bond's price to changes in interest rates. It is expressed in years and represents the weighted average time an investor must wait to receive the bond's total cash flows, including periodic coupon payments and the final repayment of the principal. The higher the duration, the greater the bond's exposure to interest rate risk. For example, if a bond has a duration of 5 years, a 1% increase in interest rates would cause the bond's price to fall by approximately 5%. This relationship between duration and price sensitivity makes it one of the most important tools in fixed income investing. Duration is widely used by portfolio managers to manage and hedge interest rate risk across fixed income investments. There are different types of duration, including Macaulay duration, which measures the weighted average time to receive cash flows, and modified duration, which directly measures price sensitivity to interest rate changes. A zero coupon bond always has a duration equal to its maturity since all cash flows are received at the end, while bonds with regular coupon payments always have a duration shorter than their maturity. Understanding duration is essential for any investor involved in bond markets, as it provides a far clearer and more accurate picture of interest rate risk than simply looking at a bond's maturity date alone. Investors who anticipate rising interest rates will typically reduce the duration of their portfolio to protect against price declines, while those expecting falling rates will increase duration to maximize gains from price appreciation.

See also