Question

In your own words based on the video and personal research, what is your interpretation of bond duration? (2) How is it calculated? (3) What is bond duration actually calculating? (4) The important item of this assignment is to manage risk in our company or personal investments. How do you think we can utilize the idea of bond duration to offset interest rate risk as they have a tendency to fluctuate?

Answer 1

(1): My interpretation of bond duration is that bond duration is a concept that helps in measuring and determining the sensitivity of bond prices to changes in interest rates. In other words this tool helps in determining how bond prices will change (or are likely to change) when interest rates move (i.e. either go up or down).

(2): Bond duration can be computed in different ways. I am providing a formula here and this is known as Macaulay duration.

Macaulay duration = sum of [tC/(1+y)^t + nM/(1+y)^n]/P

In the above equation t = period in which coupon is received, C = periodic coupon payment, y = yield to maturity, n = number of periods, M = maturity value, P = market price of bond.

(3): Bond duration is actually calculating the sum of present value of cash flows from the bond and then dividing it by its current price. For instance from the above formula if we have computed the duration to be 5.5 and suppose that yields in the market rises by 10 basis points then change in bond’s price (approximate) will be = -5.5*0.001 = -0.00550 or 0.550%.

(4): The concept of bond duration can be used to offset interest rate risk as it is with the use of this tool that we can choose investments that might better meet our future cash needs and future cash requirements. Suppose that an investor has a low risk appetite and wants to take minimal interest rate risk. In such a case the concept of duration will help the investor to consider bonds with high coupon payments and with shorter maturities.