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Duration

In: Business and Management

Submitted By maxankit
Words 2749
Pages 11
California Debt and Investment Advisory Commission

Duration Basics
Introduction
Duration is a term used by fixed-income investors, financial advisors, and investment advisors. It is an important measure for investors to consider, as bonds with higher durations (given equal credit, inflation and reinvestment risk) may have greater price volatility than bonds with lower durations. It is an important tool in structuring and managing a fixed-income portfolio based on selected investment objectives. Investment theory tells us that the value of a fixed-income investment is the sum of all of its cash flows discounted at an interest rate that reflects the inherent investment risk. In addition, due to the time value of money, it assumes that cash flows returned earlier are worth more than cash flows returned later. In its most basic form, duration measures the weighted average of the present value of the cash flows of a fixed-income investment. All of the components of a bond—price, coupon, maturity, and interest rates—are used in the calculation of its duration. Although a bond’s price is dependent on many variables apart from duration, duration can be used to determine how the bond’s price may react to changes in interest rates. This issue brief will provide the following information:

< A basic overview of bond math and the components of a bond that will affect its volatility.

< The different types of duration and how they are calculated. < Why duration is an important measure when comparing individual bonds and constructing bond portfolios.

< An explanation of the concept of convexity and how it is used in conjunction with the duration measure.

January 2007

issue brief

Basic Bond Math and Risk Measurement
The price of a bond, or any fixed-income investment, is determined by summing the cash flows discounted by a rate of return. The rate of

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