Economics
Bond Duration
Quick fact
A zero-coupon bond's duration is exactly equal to its maturity because all cash flow is received at the end. For coupon bonds, duration is always less than maturity due to earlier cash flows.
Why this is interesting
Imagine two bonds with the same maturity date—why does one drop twice as much in price when interest rates rise? The answer lies in a hidden feature called duration.
Read the full explanation
Understanding Bond Duration
Duration is often described as the 'average waiting time' for a bond's cash flows. Think of a bond as a stream of payments: coupons every year and a final principal repayment. Duration weights each payment by the time you receive it, then averages them. A bond with a 5-year maturity and large coupons has a shorter duration than a similar bond with small coupons, because you get more money earlier. This measure predicts how much the bond's price will change when interest rates move. For example, a duration of 4 years means if interest rates rise by 1%, the bond's price will fall by approximately 4%. It's a simple yet powerful way to compare the interest rate risk of different bonds.
A deeper explanation
Duration works because bond prices and interest rates are inversely related. The precise mechanism is based on the present value of future cash flows. When rates change, the discount factors for distant cash flows shift more than for near-term ones. Duration captures the weighted sensitivity of all cash flows to a change in yield. Mathematically, modified duration equals the negative percentage change in price for a 1% change in yield, derived from the first derivative of the price-yield curve. This linear approximation is most accurate for small rate changes; for larger shifts, convexity adjusts for the curvature. Financial institutions use duration to hedge interest rate risk by matching asset and liability durations (immunization). It also helps in constructing bond ladders and assessing portfolio vulnerability. Understanding duration transforms a static bond holding into a dynamic risk profile, enabling smarter investment decisions.