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Duration – of a bond

Duration, in the context of a bond, is used as a measure of the sensitivity of a bond to changes in interest rates. Expressed in years, it represents the weighted average of the time it will take to receive all the cash flows from a bond. A bond with most of its cash flows due many years from now is more sensitive to changes in interest rates than a bond where all the cash flows will be received in the near future. Duration can also be calculated for a portfolio of bonds or debt instruments.

The expectation of interest rates rising in the future would point investors to shorter-duration bonds, which have less interest-rate risk.

If a bond has a duration of 6 years, for example, its price will rise about 6% if its yield drops by a percentage point (100 basis points), and its price will fall by about 6% if its yield rises by that amount.

A bond’s duration changes with time and as its price and yield change, however. Duration measures the time it takes to recover half the present value of all future cash flows from the bond. The discount rate for calculating the present value of the cash flows is the bond’s yield. So as a bond’s price and yield change, so does its duration.

Modified duration is a formula that expresses the measurable change in the value of a security in response to a change in interest rates. Modified duration follows the concept that interest rates and bond prices move in opposite directions.

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