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January 2007
CDIAC# 06-10 California Debt and Investment Advisory Commission
Duration Basics
Introduction
Duration is a term used by fixed-income inves- determine how the bond’s price may react to
tors, financial advisors, and investment advi- changes in interest rates.
sors. It is an important measure for investors
This issue brief will provide the following infor-
to consider, as bonds with higher durations
mation:
(given equal credit, inflation and reinvestment
risk) may have greater price volatility than < A basic overview of bond math and the compo-
bonds with lower durations. It is an important nents of a bond that will affect its volatility.
tool in structuring and managing a fixed-in-
come portfolio based on selected investment
< The different types of duration and how they are
calculated.
objectives.
The price of a bond, or any fixed-income in- Changes in the value of a bond are inversely
vestment, is determined by summing the cash related to changes in the rate of return.
flows discounted by a rate of return. The rate The higher the rate of return (i.e., yield to matu-
of return can change at any time period and rity (YTM)), the lower the bond value.
will be reflected in the calculation of an invest-
ment’s market price. Long-term bonds have greater interest rate
2 risk than short-term bonds.
The price of a bond can be calculated using
There is a greater probability that interest rates
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Definitions:
|Coupon Cash
Flows | |Repayment
Principal
| In other words, the more cash flow received in
the short-term (because of a higher coupon), the
CPN = coupon payment faster the cost of the bond will be recovered. The
P = principal payment same is true of higher yields. Again, the more a
YTM = yield to maturity bond yields in today’s dollars, the faster the inves-
n = number of compounding periods tor will recover its cost.
t = time period
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vestments being analyzed (e.g., bullet securities
versus callable securities) and the preference for
calculating the measure using generally available
in-house tools (which can be used to calculate
Macaulay or modified duration) versus purchas-
ing or relying on software that will create a simu-
lation model of various interest rate scenarios for
calculating effective duration.
Yield to maturity
Using the Macaulay duration formula in Fig- 1+
ure 2, duration can be calculated as: Number of coupon
periods per year
Principles of Duration
As used in the equations in Figures 1 through
3 above, coupon rate (which determines the
size of the periodic cash flow), interest rates
(which determines the present value of the pe-
riodic cash flow), and maturity (which weights
each cash flow) all contribute to the duration
measures.
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in interest rates.
Portfolio Duration
Duration is important to bond portfolio manag-
ers. The duration of a portfolio is the weighted
average duration of all the bonds in the portfolio
weighted by their dollar values (see Figure 4 for
an example).
A $100,000 .10 4 .4
Figure 6 – Convexity
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Convex relationship
between price and yield
Price
Duration Line
Difference Duration and convexity are important measure-
captured ment tools for use in valuation and portfolio man-
by convexity
measure agement strategies. As such, they are an integral
Yield part of the financial services landscape. Duration
and convexity functions are available in numer-
ous financial management software packages
The more convex the relationship the more in- and through Microsoft Excel. Bloomberg L.P.
accurate duration is as a measure of the inter- also includes the measures as a standard compo-
est rate sensitivity. nent of their bond presentation screens.
Advisory Commission
<
phone 916.653.3269
<
fax 916.654.7440
<
email cdiac@treasurer.ca.gov
<
website www.treasurer.ca.gov /cdiac
References Acknowledgements
The following publications were used as refer- Douglas Skarr, Research Program
ence resources for the development of this issue Specialist II, authored this Issue Brief and
brief: Kristin Szakaly-Moore, Director of Policy
Research, reviewed it.
F. Fabozzi, editor. The Handbook of Fixed Income
Securities (Seventh Edition). The McGraw-Hill CDIAC thanks the following Technical
Companies. 2005. Advisory Committee members for their
comments and review of this document:
C. Corrado and B. Jordan. Fundamentals of
Investments—Valuation and Management (Third Ned Connolly, Chandler Asset Management,
Edition). The McGraw-Hill Companies. 2005. Inc.,
Deborah Higgins, Higgins Capital, and
J. Place. Basic Bond Analysis (in “Handbooks in Tom Walsh, Franklin Templeton Investments.
Central Banking”). Centre for Central Banking
Studies, Bank of England. 2000.
© All Rights Reserved. Permission is granted to use this document with written credit given to CDIAC.