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Duration

There are two main types of duration: 1) Macaulay Duration measures the number of years until the present value of the bond's cash flows equals the price paid. It is calculated by taking the weighted average of the time until each cash flow, weighted by its present value. 2) Modified Duration approximates the percentage change in bond price from a change in yield, rather than re-calculating the price from scratch. It is calculated using the Macaulay Duration and yield-to-maturity. Modified Duration allows investors to quickly estimate how a bond's price will change as interest rates change.

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43 views

Duration

There are two main types of duration: 1) Macaulay Duration measures the number of years until the present value of the bond's cash flows equals the price paid. It is calculated by taking the weighted average of the time until each cash flow, weighted by its present value. 2) Modified Duration approximates the percentage change in bond price from a change in yield, rather than re-calculating the price from scratch. It is calculated using the Macaulay Duration and yield-to-maturity. Modified Duration allows investors to quickly estimate how a bond's price will change as interest rates change.

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dude
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© Attribution Non-Commercial (BY-NC)
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Duration There are several forms of duration, of which we Macaulay and Modified duration are the most prevalent.

Macaulay Duration
Macaulay Duration is a measure of the number of years it takes to return the economic value to an investor equal to the price that was paid. How do we calculate Macaulay Duration? There are several methods to calculating Macaulay Duration, but arguably the most straightforward approach is the following: 1) Calculate the price of the bond: Assume that we have a 5-year bond, with a 5% coupon rate (paid semiannually), par value of $1,000 and interest rates floating at 3% (assume the yield curve is flat): t= 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 Price Cash Flow $25 $25 $25 $25 $25 $25 $25 $25 $25 $1,025 Present Value $24.63 $24.27 $23.91 $23.55 $23.21 $22.86 $22.53 $22.19 $21.86 $883.21 $1,092.22

Considering the time value of money, how long will it be before we receive our original investment of $1092.22 as time progresses. In other words, how long will it be before we receive the economic value. 2) Calculate weighted present values: To do this, we weight the present value of our cash flows by the time period that they were received. For example, at t=.5 we multiply the following:

This is the weighted present value of the cash flow at time t=0.5 otherwise known as the weighted economic value for a single coupon. We continue this process and get the following:

t= 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 Price/Total

Cash Flow $25 $25 $25 $25 $25 $25 $25 $25 $25 $1,025

Present Value $24.63 $24.27 $23.91 $23.55 $23.21 $22.86 $22.53 $22.19 $21.86 $883.21 $1,092.22

Weighted Present Value $12.32 $24.27 $35.86 $47.11 $58.02 $68.59 $78.84 $88.77 $98.39 $4,416.04 $4,928.21

3) Sum the weighted present values and divide by the price: We have calculated the weighted present value for each cash flow and summed them up: $4,928.21. The final step is to divide the weighted present value by the price of the bond:

4.51 is the Macaulay duration. It should be interpreted as the number of years. In this case, it takes approximately 4.51 years for the price of a bond to pay for itself and return its fair economic value back to the investor. For an illustrative understanding, consider the following Investopedia article: http://www.investopedia.com/university/advancedbond/advancedbond5.asp#axzz29a5zGxLM

There are a few assumptions (among many) for Macaulay Duration: A) Interest rates are fixed throughout the life of the bond. If these rates change, not only does the price change, but the Macaulay Duration will change as well. B) That time is static. As time progresses the duration will change less time, less duration. However, this will not affect the overall exact date when the economic value is returned, ceteris paribus.

Modified Duration
Since the interest rate is always floating, we must consider the effects of impacts on the value of our bond given these changes. Instead of recalculating the price of the bond once interest rates change, we can approximate these changes with Modified Duration.

The first part would be to know what the Macaulay Duration is. Once calculated, we must also know the yield-to-maturity of a bond. The yield-to-maturity is the internal rate of return of a bond the single, fixed interest rate that sets the present value of all cash flows equal to the price of the bond. With Macaulay Duration and the yield-to-maturity, we calculate Modified Duration as the following:

Taking our original bond:

Notice that the yield-to maturity used here is equal to the interest rate for the yield curve. Since the yield curve is flat, this makes sense. However, if the yield curve were sloping, this number would be completely different. The units of modified duration are Price/Yield. We can use modified duration to approximate the percentage change in a bonds price given a basis point change in the yield with the following formula:

Put into practice, we can approximate the change in price given a change of +100 BPS:

Using this change, we can calculate an approximate new price:

Since this is an approximation, if we recalculate the bond price from the beginning, we arrive at the actual price of $1,044.91. So, modified duration over-estimated the price decline by $1.24.

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