FIXED
INCOME SECURITIES 9-39
Yield to
maturity
·
The duration of a coupon bond is higher when the bond's yield to
maturity is lower, holding all other factors constant.
Recall that our calculation of duration requires that the cash flows
be discounted by the yield to maturity rate (bond equivalent rate).
A smaller discount rate places less value on earlier cash flows in
the discounting process.
Analysts use duration to track the sensitivity of bond prices to
changes in interest rates.
Example
Suppose that you have to decide whether to invest in an 8% coupon
rate with a 20-year maturity or a 12% coupon rate bond with a 25-
year maturity. Which bond will have the larger increase in price if
interest rates decline?
The bond with the shorter maturity (8% coupon rate for 20 years)
has a longer duration than the bond with the greater maturity (12%
for 25 years) and, thus, is the most price sensitive.
Summary
Duration represents the weighted average life of the bond. The
weights are based on the present value of the individual cash flows
relative to the present value of the total cash flows (current price of
the bond).
The longer the duration, the greater the impact of a change in
interest rates on price.
The duration of a coupon bond is higher when the bond's yield to
maturity is lower.
The higher the coupon rate, the lower the duration.
Duration is primarily used as a measure to judge bond price
sensitivity to interest rate changes.