I keep reading that duration is
How sensitive a bond is to fluctuations in competing interest rates
A CFA candidate once told me that bond duration is helps indicate how fast an investor gets his money back. Is there any truth to that statement?
The CFA candidate is right. What you keep reading is right.
Well it depends on what type of duration you’re talking about. Macaulay duration is the weighted average number of periods it’ll take to get your coupons and principal back. Modified duration is the percentage change in price for a 1% change in yield and effective duration is the percentage change in price for a 1% change in the yield curve.
Perhaps this article I wrote will be of some help: http://financialexamhelp123.com/macaulay-duration-modified-duration-and-effective-duration/.
The difference between modified duration and effective duration is not one focuses on the YTM for that bond and the other focuses on the entire yield curve. The difference is that modified duration assumes that the cash flows don’t change when the bond’s YTM changes, whereas effective duration allows that the cash flows might change when the bond’s YTM changes.
Know this–for purposes of the CFA exam, there is only one kind of duration, and that’s effective duration. Macaulay and modified are NOT part of the CFA exam.
Duration commonly has two uses. One–it tells you what the “time-weighted average” of the cash flows from a bond are. So if a bond has a duration of 5.5, then it’s weighted average of all discounted cash flows (including principal repayment) is 5.5 years. (Note that this is NOT part of CFA curriculum either.)
The second, and more importantly, it tells you the sensitivity of the bond’s price to interest rate changes. That is, if a bond has a duration of 5.5, then a 1% increase in interest rates will cause the bond’s price to decrease by 5.5%.
Okay so I think I see where this going. If there is no call option built-in, then cash flow won’t change even when current competing rates change (since the issuer can’t call the bond and disrupt the scheduled cashflow). So am I to conclude that modified duration works when there is no call or put option, but is useless if there
A) is a call option AND
B) the competing interest rate (or YTM) moves farther away from the YTM at time of sale?
LOL - you should write the textbooks for a living. That bolded statement managed to communicate like 30 pages of text in one line. I don’t know why all these youtube and investopedia authors have to make it so difficult! Thanks so much.
When you say McCaulay duration isn’t part of the exam, do you mean “it’s not part of level ONE” or “it’s not on the exam at all”? I ask because I’m seeing a lot of internet material mentioning it in the title. Maybe they added it to the curriculum since you got your CFA a few years back?
Modified duration is not useful whenever the cash flows may change. Cash flows may change because:
- the bond has embedded options: call option, put option, prepayment option, conversion option
- the coupon rate on the bond isn’t fixed: floating-rate bonds
This, my friend, is the difference between Schweser and CFAI. Schweser cuts out 29 of the 30 pages, and just tells you what you need to know, without all of the fluff and stuff.
I passed Level 1 in December 2010, so not that long ago. It’s possible that it has changed, but I doubt it. And it’s not on the exam at all, in any level.
The current L1 reading has some intuition on Macauley that’s new this year. In particular, there’s material that links the relative impact of price and reinvestment risk on total return when the YTM changes to Maculey Duration.
The Cliff notes version is:
if investment horizon is < Macauley duration, the price risk effect dominates, and an increase in interest rates decreases investors’ return
if investment horizon > Macauley, the reinvestment effect dominates (i.e. intervening coupons get to be reinvested at higher rates over a long time, resulting in more reinvestment income), and an increase in interest rates will increase investor’s return.
that makes sense, thanks
busprof often does.
I figure if I bloviate long and often enough, I’ll eventually say something that makes sense. Glad it helped.
Bond duration refers to the relation between change in Bond prices with respect to change in interest rates. A bond with high duration is more sensitive to the prices with respect to change in interest rates and a bond with less duration is less sensitive to the to the prices with respect to change in interest rates.