Interest rate and duration relationship

Duration - Full Explanation & Example | InvestingAnswers

interest rate and duration relationship

Investors use duration to predict bond price changes. Duration is a measure of a bond's interest rate risk. It is the weighted average of the time periods until a. Duration is a measure of a bond's sensitivity to interest rate changes. The formula assumes a linear relationship between bond prices and yields even though. The higher the duration number, the more sensitive your. A maxim of bond investing is that when interest rates rise, bond prices fall, and vice Investment professionals use the term "convexity" to describe this relationship.

Updated: Duration—What an Interest Rate Hike Could Do to Your Bond Portfolio | knifedirectory.info

Bonds with shorter durations are less sensitive to changing rates and thus are less volatile in a changing rate environment. Why is this so? Because bonds with shorter maturities return investors' principal more quickly than long-term bonds do.

Therefore, they carry less long-term risk because the principal is returned, and can be reinvested, earlier. This hypothetical example is an approximation that ignores the impact of convexity; we assume the duration for the 6-month bonds and year bonds in this example to be 0. Duration measures the percentage change in price with respect to a change in yield.

interest rate and duration relationship

FMRCo Of course, duration works both ways. If interest rates were to fall, the value of a bond with a longer duration would rise more than a bond with a shorter duration. Using a bond's convexity to gauge interest rate risk Keep in mind that while duration may provide a good estimate of the potential price impact of small and sudden changes in interest rates, it may be less effective for assessing the impact of large changes in rates. This is because the relationship between bond prices and bond yields is not linear but convex—it follows the line "Yield 2" in the diagram below.

This differential between the linear duration measure and the actual price change is a measure of convexity—shown in the diagram as the space between the blue line Yield 1 and the red line Yield 2.

Relationship between price and yield in a hypothetical bond The impact of convexity is also more pronounced in long-duration bonds with small coupons—something known as "positive convexity," meaning it will act to reinforce or magnify the price volatility measure indicated by duration as discussed earlier.

Understanding bond duration - Education | BlackRock

Keep in mind that duration is just one consideration when assessing risks related to your fixed income portfolio. Credit risk, inflation risk, liquidity risk, and call risk are other relevant variables that should be part of your overall analysis and research when choosing your investments.

Viewing and using duration data on Fidelity. A similar investment grade bond with a duration of The higher level of loss for the longer-term bond happens because its duration number is higher, making it react more dramatically to interest rate changes.

Duration: Understanding the relationship between bond prices and interest rates

Duration has the same effect on bond funds. For example, a bond fund with year duration will decrease in value by 10 percent if interest rates rise one percent. On the other hand, the bond fund will increase in value by 10 percent if interest rates fall one percent.

Finding the duration of an individual bond can be a bit trickier. In some cases, more than one duration number is computed.

What is bond duration?

In general, six things affect a bond's duration: The higher a bond's coupon, the more income it produces early on and thus the shorter its duration. The lower the coupon, the longer the duration and volatility. Zero-coupon bonds, which have only one cash flowhave durations equal to their maturities. The longer a bond's maturity, the greater its duration and volatility. Duration changes every time a bond makes a coupon payment.

Over time, it shortens as the bond nears maturity.

interest rate and duration relationship