Duration

Duration helps the investor compare bonds with different maturities or redemption periods.

Duration typically describes the interest rate sensitivity of bonds or other credit instruments, i.e. the change in bond value caused by changes in market interest rates, using the average of the remaining maturities associated with the payments of a given fixed interest security on the in the capital market.

This sounds pretty scary, so let's start with an example. 

Let's take two a bond, each with a nominal/face value of $1,000, paying interests annually, with an annual interest rate of 5 percent. The difference between them should be that one has a 2-year maturity, while the other has a 10-year maturity. In this case, even though the other basic parameters of the bonds are the same, the average term of the two-year bond, i.e. the remaining maturity until interest payments, will be lower than that of the other bond. As a result, the interest rate risk embodied in it is also lower.

The average time is therefore not equal to the maturity of the bond, although both are measured in years. The longer the maturity period, the higher the average term and the higher the average interest rate risk. In other words, the average time shows the average amount of time left until each payment, weighted by the size of the present value of the payments. 

The interest rate interest rate sensitivity of a bond can also be shown with the help of its duration: the longer the duration, the greater the price drop for a one-unit increase in market interest rates. The reverse is also true: the longer the duration, the greater the increase in the exchange rate for a one-unit decrease in interest rates. The interest rate sensitivity of bonds with a short remaining maturity is by definition lower.

As a rough estimate, a 1% change in the market interest rate means a 1% change in the opposite direction in the yield of the bond yield. So if the bond matures in 5 years and the market interest rate increases by 1 percent, the bond price will decrease by 5 percent. 

Another version of duration is "modified duration", which is not measured in years, but describes the expected change in the price of the bond in the event of a 1 percent change in the interest rate. Bond prices are inversely related to interest rate changes. Rising interest rates indicate that bond prices will fall. Falling interest rates predict an increase in the price of bonds.