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Using DURATION to Understand Price Volatility
Using
Using DURATION
DURATION to Understand Price Volatility
to Understand Price Volatility
Durationis a measurement, in years, of how long it takes for the price of a
bond to be repaid by its cash flows. This measurement is not relevant for
zero-coupon bonds because with a zero-coupon bond, the duration is simul-
taneous with the maturity date.
Suppose that you have a 20-year bond with a 9% yield that pays interest
twice a year. It might take about 6 years of interest payments before you earn
back the original purchase price of the bond.
Duration is constantly changing. Immediately after a coupon date, the dura-
tion goes up slightly because the interest payment is no longer counted as a
future cash flow. However, over the life of the bond, the duration gets pro-
gressively shorter, until the duration date corresponds with the maturity
date. Duration is important because the higher the duration, the higher the
price volatility for the security.
When Excel uses the DURATION function to calculate a duration, it uses the
method designed by Frederick Macaulay in the 1930s. This method multiplies
the present value of each cash flow by the time it is received. Those values
are summed and divided by the total price for the security.
Excel also has a modified duration function, MDURATION. This function cal-
culates the duration if the yield would increase by 1 percentage point. In Fig-
ure 13.26 , the duration for the 5% yield is 6.879 years. The MDURATION return
is 6.712 years. This is the duration if the yield would change from 5% to 6%.
The difference between the duration and modified duration is an indicator of a
bond price s volatility.
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