After the shock that hit the financial markets over the past two years, investors are considering fixed-income assets but lack the tools to understand how they react to changes in interest rates. A basic metric known as duration can help investors understand the risks associated with debt.
Duration may be confusing to some since it's typically quoted either as a straight number or in years. The two forms are the same but viewed in different ways. When it's quoted in years, the number refers to the time before the initial investment is repaid. As such, a zero-coupon bond's duration is equal to its maturity. Securities that carry coupon payments will have durations that are less than maturity.
The more useful interpretation of duration views the number as the security's sensitivity to interest rate changes. Duration is the percentage change in the price of a security for a 100 basis point (bps) parallel shift in the yield curve. As a result, high-duration securities will be much more volatile when interest rates change than shorter-duration securities will be.Calculating duration requires a bit of fiddling or a computer that runs Microsoft's (MSFT) Excel. If you know the coupon, yield, price, settlement date and maturity date, the duration function in Excel can calculate the number. Otherwise, you need to recalculate the price of the bond with identical 100 bps increases and decreases in the yield.
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