What Is A Duration Of A Bond?
It gets the investor qualified to receive a fixed income after a predetermined period of time. The fixed income comes as a consequence of the fixed cost and interest on bonds. A bond is the most elementary unit of debt generally issued by businesses.
Bonds have some special characteristics. They generally have a face value, which is the amount that the bond will be worth at maturity. The face value of this bond may not be the same as its issue price, which is the value that the borrower receives for the bond.
Similarly, bonds also have coupon rates and coupon dates, which are the rates and dates of interest payments. Bonds also have a maturity date, which is the date where the bond is repayable.
The length of a bond doesn’t signify the duration for which an investor holds a bond. Instead, it describes the relationship between the price of a bond and interest rates of this bond after contemplating its distinct characteristics like yield, coupon rate, maturity etc..
Usually, the length of a bond indicates the amount of years where an investor can recover the present value of the cash flows a bond. It can also represent a percent that is a measure of just how sensitive the value of this bond would be to changes in interest prices.
The duration of a bond is straightforward to understand. The higher the length is, the higher is its susceptibility to fluctuations in interest prices. This is mainly because as soon as the interest rates go up, the value of a bond will fall.
In the same way, bonds with a decrease duration will not be affected as much by interest rate varies. In the long term, if an investor expects the interest rates to move up, they will dispose off their bonds while should they expect them to return, they’ll continue to their own bonds. The relationship between the price of a bond and interest levels is inverse.
Is the duration of bond distinct from its maturity?
While the duration of a bond and bond maturity may equally sound similar because they consider a time linked to bond, they are both distinct. On the flip side, the maturity of a bond is a period in the future on which the investor will receive the last cash flow from the bond.
The way to figure out the duration of a bond?
There are two ways to compute the duration of a bond. Both of these represent different characteristics of the length of a bail but are interrelated.
The very first means to figure out the duration of a bond would be using a model called the Macaulay duration. Using the model, the aggregate of the current value of all cash flows in the bond is divided by its current market price. The model calculates the time the current value of cash flows in the bond takes to realize. The simplified formula for Macaulay duration is as below:
The cash flows of a bond consist of interest payment and the final interest and principal payment made to the shareholders. They may be calculatable because bonds have a fixed income. This results gained from this version are in the kind of a number of years.
Another model used to calculate the duration of a bond is that the modified length version. While the Macaulay duration represents the time required for the present value of cash flows from a bond to achieve , the modified duration represents the sensitivity of the price of the bond in regard to the interest prices.
Modified length = Macaulay length / (1 + Yield To Maturity of this bond)
The results obtained from this version are in the form of a percentage. As stated above, the higher this percentage is, the greater the reverse relationship between the purchase price of a bond and the interest rates will be.
Bonds come with fixed-income interests payable at predetermined dates. The duration of a bond signifies the relationship between the price of a bond and interest rates.
Normally, the association between both is reverse, which means when interest rates are high, the price of the bond will fall and vice versa. The duration of a bond is different from its maturity as both current different time intervals of a bond. There are two approaches to compute the duration of a bond, Macaulay length and Modified duration.