Concept Corner

Understanding Duration

Duration – A Measure of InterestFund Positioning Rate Risk Funds - Duration and its Significance prices share an inverse relationship with interest rates, i.e. when Duration is calculated using , , , final interest rates go up, bond prices go down and when interest rates go and call features if any. For investors, Duration numbers down, bond prices go up. This price sensitivity of the bond to change in are disclosed by the Asset Management Companies (AMCs) for their interest rates can be measured using ‘Duration’. It is an important debt schemes. The average Modified Duration of a fixed income scheme measure to be considered while investing in fixed income securities, as it indicates how sensitive the fund will be, to changes in the interest rates. helps to determine how the price of a bond will change as a Broadly, it indicates the fund manager’s view on interest rates. If a result of a change in interest rates. mutual fund scheme is having a lower Duration, this indicates that the Generally, there are two main types of duration calculations; Macaulay fund manager expects interest rates to increase and therefore, Duration and Modified Duration and both are measured in years. maintains a low Duration in order to protect the portfolio from rising Macaulay Duration is a measure of how long it takes for the price of a interest rates. Similarly, if the fund manager foresees a declining bond to be repaid by its internal cash flows. Macaulay Duration is used scenario, the Duration of the portfolio will be kept higher so only for an instrument with fixed cash flows. Modified Duration as the as to take advantage of falling interest rates. Furthermore, Duration can name suggests, is a modified version of the Macaulay model that offer a good comparison while evaluating one fund’s accounts for changing interest rates. It measures the change in the with that of another, as returns are affected by changes in value of a fixed income that will result from a 1% change in the the interest rates. interest rate. The percentage change in the bond price is equal to change in the interest rate multiplied by Modified Duration. For example, Summing Up if the interest rate moves up by 100 bps or 1%; say from 5% to 6%, the Knowing the Modified Duration of a debt fund portfolio, helps investors price of a bond with a Duration of 5 years will move down by understand the price sensitivity of the debt fund portfolio to interest approximately 5%, while a bond with a Duration of 10 years will move rate risk and match investments as per one’s risk profile and financial down by about 10%. On the contrary, if the interest rate moves down by goals. For instance, investors who foresee a decline in interest rates 100 bps or 1%; say from 5% to 4%, the price of a bond with a Duration would try to increase the average Duration of their debt portfolio, while of 5 years will move up by approximately 5%, while a investors who anticipate an increase in interest rates would look to bond with a Duration of 10 years will move up by about 10%. reduce the average Duration of their portfolio. Furthermore, investors Interest Rates, Duration and Bond Prices with a low risk appetite and a short term investment horizon would generally look to invest in low Duration papers as these securities are Price of Change In Duration Approximate Approxi- less sensitive to changes in the interest rates; relative to bonds with a Bond Interest of The % Change In mate Bond higher Duration. Rates Bond Bond Prices Prices Post Due To Change In In conclusion, it is important for investors to consider Duration while Interest Rate Interest making investments in fixed income instruments as it helps to measure Movement Rate the volatility of the bond portfolio. Generally higher the Duration, the ` 1000 +1% 5 Years -5% ` 950 longer an investor needs to wait for the bulk of payments or; the price will ` 1000 -1% 5 Years +5% ` 1050 decline more with the rise in the interest rates. However, there are several other factors, which affect bond prices such as credit quality of the Thus, by knowing the Duration of a bond/portfolio, one can portfolio, macroeconomic environment, etc. Since Duration is one of the approximately estimate the likely change in bond prices. However, this measures to estimate the price sensitivity of bonds, it should be looked at approximation becomes less accurate for large changes in interest rates. in conjunction with other factors, which may also affect bond prices.

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