What is Duration ?
Definition of Duration
Duration in general term means the time period for which something continues.
In Business or finance term means sensitivity to yield of price during a period of time or rate of change in price with respect to yield. It is normally associated with fixed cash flow assets. It is the number of years required to receive the present value of future payments.
Brief Explanation of Duration
It is measured in years and therefore if a bond or security or asset is said to have longer duration means investor would have to wait long for receive back its interest and principal price.
Bonds which can be redeemed at some later date are more exposed to interest rate changes because of the unforeseeable future and are therefore riskier.
It lets you compare bonds and securities of different price and interest rates and helps you make a decision according to your need and circumstances.
The duration calculation involves present value, yield, bond price and duration period. As bond coupon increases its duration decreases and also its sensitivity also decreases.
There are two main types of Bond Durations:
Macaulay : It is defined as the weighted average maturity of cash flows.
Modified : It is defined as measure of price sensitivity of bond to interest rate movement.
Its interest rate have different logic, let us say if interest rate changes by 2 % the bond is likely to change inversely by 2% for each year.