Here's A Quick Intro Into Different Types of Duration
Yes, I know all fixed-income and typical investors understand what duration is and its importance. However this article is for the people who are just learning about finance and are hungry to see what is out there, I'm here to help and offer my understanding on the topic as I continue my journey in learning the art of finance.
Duration is both very important, and is very damn interesting. There are many types of duration and it can explain unique characteristics about a bond.
The following are different types of duration:
- Macaulay Duration: This type of duration measures the number of years it takes to cover the true cost of a bond
- Modified Duration: Measures the sensitivity of a bond's price with respect to a 100 bps change in interest rates (For example: If a bond's duration is 5 years, an interest rate change of +100 bps will result in an approximate 5% decrease in the price of the bond and vice versa
- Effective Duration: The measure is useful for a portfolio carrying bonds, and this form of duration calculates a single number that indicates how sensitive a bond portfolio is to a change in interest rates, think of it as a modified duration for a bond portfolio
By better understanding duration investors can better structure the interest rate sensitivity of their bonds and bond portfolio. Bond's with a higher duration carry greater risk, however there is the potential for greater returns. If interest rates are expected to drop in the near future, which in the current market isn't expected, the bond with a greater duration would have a larger increase in price as opposed to a bond with a shorter duration. On another note this also means that bonds with a longer duration in today's market are subject to more risk once interest rates begin to rise.
Where Convexity Comes In:
I won't go too in-depth with convexity, however there are important points to make with this concept. Duration makes an assumption that there is a linear relationship between a change in interest rates and bond price. Convexity measures the rate change in duration, thus capturing a more accurate relationship between price and interest rates.
Conclusion:
I understand these are basic concepts in fixed-income investing, yet I am here to educate and share my thoughts as I learn. If you have any comments and want to add something please feel free to post them below, I hope you enjoyed the reading!
I appreciate the post man - it's funny because I am in the middle of studying for my second shot at CFA Level I and just looked over the Fixed Income section on duration - it's nice to see a diluted, easier to understand version to reinforce.
Great post! Thanks for writing this.
If I have an interview for a fixed income analyst position, what kind of questions should I expect?
What else should I be aware of beyond duration and convexity?
Thanks for the write up!
I have some in regards to Modified Duration. What interest rate is the 100 bps move referencing? For example; if it was a 10 year duration, are we comparing it to a 10 yr treasury rate move? If so, how would shorter term rates affect the duration? Or is it assuming a linear drop across all interest rates?
I may be confusing this concept with convexity? But I thought that meant that as you move up/down rates, those new rates will all have different effects on your duration.
Sorry for all the questions and thanks again.
Duration is quoted as a percentage. It is the % change in the price of the bond for a 100bp change in the YTM. Duration increases as rates decrease because the price becomes more sensitive to interest rate risk.
Convexity is a measure of the curvature of the yield curve, its the derivative of duration. If you don't know calculus it is the rate at which duration changes.
If you want to be precise, this is wrong. Convexity measures the second order price change with respect to interest rates, ie how much the linear approximation is off by. That's not exactly the same thing as the change in duration with respect to rates.
Good stuff...for quants here are important formulas used in FI: 1. Modified duration: ∆P/P≈-D(mod)∆Y 2. Modified duration: D(mod)≈(Pnegative-Ppositive)/2∆Y(Pinitial) 3. Convexity: ∆P/P≈-D(mod)∆Y+0.5C(∆Y)^2 4. Convexity: C≈(Pnegative+Ppositive)-(2Pinitial)/(∆Y)^2(Pinitial)
Thanks mate!
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