Does anyone know why the book link the effective duration to the maturity of the bond? like a zero coupon bond ED = maturity of the bond? isnt ED measures the sensitivity of the bond price to the yield? came accross a lot of questions asking about strategy if you want to increase or decrease the duration of the portfolio? Can someone please kindly explain? thanks in advance!!!
I believe it refers to both, 2 for 1! For the purpose of the exam I just remember the formula if they ask to calculate and the theory if they ask about strategy. Hope this helps… Per Investopedia: Duration measures how long it takes, in years, for an investor to be repaid the bond’s price by the bond’s total cash flows. At the same time, duration is a measure of sensitivity of a bond’s or fixed income portfolio’s price to changes in interest rates. In general, the higher the duration, the more a bond’s price will drop as interest rates rise (and the greater the interest rate risk). As a general rule, for every 1% change in interest rates (increase or decrease), a bond’s price will change approximately 1% in the opposite direction, for every year of duration.
The duration of a bond in practice can refer to two different things. The Macaulay duration is the weighted average time until all the bond’s cash flows are paid. By accounting for the present value of future bond payments, the Macaulay duration helps an investor evaluate and compare bonds independent of their term or time to maturity.
The second type of duration is called “modified duration” and, unlike Macaulay duration, is not measured in years. Modified duration measures the expected change in a bond’s price to a 1% change in interest rates. In order to understand modified duration, keep in mind that bond prices are said to have an inverse relationship with interest rates. Therefore, rising interest rates indicate that bond prices are likely to fall, while declining interest rates indicate that bond prices are likely to rise.
Unfortunately, like many articles in Investopedia, this one has errors, such as the one above; all – _ all! _ – durations have years as their units. Macaulay duration, modified duration, effective duration, spread duration, key rate duration, empirical duration: all of them.
Modified duration measures the sensitivity of a bond’s price to a change in its yield to maturity, assuming that the bond’s cash flows _ do not change _ when the yield changes.
Effective duration measures the sensitivity of a bond’s price to a change in its yield to maturity, allowing that the bond’s cash flows _ might change _ when the yield changes.
For bonds whose cash flows do not change when their yields change, modified duration and effective duration are equal. For bonds whose cash flows might change when their yields change (e.g., callable bonds, putable bonds, floating rate bonds), modified duration and effective duration might differ from each other.
In general, effective duration is a better measure of interest rate sensitivity than modified duration.
Thank you both!
My pleasure.