Why you need to understand duration.

• Author: Scott, David L.
• Position: Finance

Why you need to understand duration

The concept of duration was developed more than five decades ago to show that maturity length is not necessarily the best measure of time in judging a fixed-income investment. Rather, an investor must consider the timing and relative size of all of the cash flows from an investment, including both interest payments and the eventual return of principal. Basically, duration is a measure of the weighted average time to recover both interest and principal.

Despite its relative advantages both in measuring price volatility and in providing assistance for reducing the interest rate risk of a fixed-income portfolio, duration receives little coverage. Given increasingly volatile interest rates and an unstable yield curve, however, an understanding of this measure of interest rate-induced price volatility is quite relevant to chief financial officers, whether functioning in the capacity of fund raisers or investment managers.

The concept of duration is generally presented from the viewpoint of the investor or the portfolio manager. Because duration is superior to maturity length for judging the price volatility of a fixed-income security, the concept has important applications for financial officers managing investment portfolios. Duration also incorporates both changing market values and changing returns from the reinvestment of cash to provide a better measure of the return an investor will earn on a fixed-income security.

Price volatility

It is well known that rising interest rates force bond values downward, while falling interest rates generate price increases for fixed-income securities. The longer the maturity of a security, the greater the change in price for a given change in interest rates. Bonds with long maturities are thus considered to have significantly more interest rate risk than do bonds with relatively short maturities.

The change in a security's price caused by a given change in interest rates is also a function of the security's coupon size. Fixed-income securities with large coupons tend to be affected to a lesser extent by interest rate changes than are low-coupon securities. Many investors have discovered to their sorrow that zero-coupon bonds, securities that make only a single cash payment at maturity, are subject to substantial fluctuations in market values whenever even relatively modest changes in interest rates occur.

Thus, there are really two interacting factors - maturity length...