What does duration tell you about the sensitivity of a bond portfolio to interest rates. What ar

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What does duration tell you about the sensitivity of a bond...

Key Concepts

Duration

Duration is a measure of the weighted average time until a bond’s cash flows are received, providing an estimate of how sensitive a bond's price is to changes in interest rates. It reflects the approximate percentage change in a bond’s price for a 1% change in interest rates, making it a key tool for managing a bond portfolio's interest rate risk.

Modified Duration

Modified Duration adjusts the basic duration measure to more directly quantify the price sensitivity of a bond or bond portfolio to yield changes. It estimates the percentage change in price for small changes in yield and is particularly useful for comparing bonds with different coupon structures.

Interest Rate Sensitivity

This concept describes how bond prices react to changes in market interest rates. Duration serves as a proxy for this sensitivity, indicating that a longer duration implies a higher susceptibility to interest rate fluctuations, while a shorter duration implies lower sensitivity.

Convexity

Convexity measures the curvature of the price-yield relationship, addressing the non-linear effects on bond prices for larger interest rate changes. It complements duration by providing a more accurate prediction of price changes when interest rates shift significantly, thus highlighting a limitation of duration’s linear approximation.

Limitations of Duration

Duration is based on several simplifying assumptions, such as a constant yield curve shift (parallel shift) and static cash flows, which may not hold true in real market conditions. It only provides an approximation for small yield changes and does not account for non-linear price changes, reinvestment risk, or other factors that affect a bond's actual performance under varying interest rate environments.

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