Option duration. Quick Reference

Duration Summary What Is Duration?

option-adjusted duration

Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates. A bond's duration is easily confused with its term or time to maturity because they are both measured in years.

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However, a bond's term is a linear measure of the years until repayment of principal is due; it does not change with option duration interest rate environment. Duration, on the other hand is non-linear and accelerates as time to maturity lessens. Key Takeaways Duration, in general, measures a bond's or fixed income portfolio's price sensitivity to interest rate changes.

Effective Duration

A fixed income portfolio's duration is computed as the weighted average of individual bond durations held in the portfolio. At the same time, duration is a measure of sensitivity of a bond's or fixed income portfolio's price option duration changes in interest rates.

In general, the higher the duration, the more a bond's price will drop as interest rates rise and the greater the interest rate risk.

The longer the maturitythe higher the duration, and the greater the interest rate risk. A bond that matures faster—say, in one year—would repay its true cost faster than a bond that matures in 10 years. Consequently, the shorter-maturity bond would have a lower duration and less risk. Coupon rate.

If we have two bonds that are identical with the exception on their coupon rates, the bond with the higher coupon rate will pay back its original costs faster than the bond with a lower yield. The higher the coupon rate, the lower the duration, and the lower the interest rate risk The duration of a bond in practice can refer to two different things.

The Macaulay duration is the weighted option duration time until all the bond's cash flows are paid. By accounting for the present value of future bond payments, the Macaulay duration helps an investor evaluate and compare bonds independent of their term or time to maturity.

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The second type of duration is called " modified duration " and, unlike Macaulay duration, is not measured in years. In order to understand modified duration, keep in mind that bond prices are said to have an inverse relationship with interest rates. Fortunately for investors, this measure is a standard data point in most bond searching and analysis software tools.

Because Macaulay duration is a partial function of the time to maturity, the greater the duration, the greater the interest-rate risk or reward for bond prices.