One of the regular risks, interest bearing instruments like bonds are prone to is
the interest rate risk, which is the variation in the price of the instrument in relation to the changes in the general interest rates. The concept of duration' is the effective way of determining and mitigating the effects of interest rate alternations. It measures the sensitivity of the bond's price to movements in interest rates and determines in how many years a bond shall repay its true cost.
Duration of a bond is usually calculated as a percentage reduction in the price of the instrument to the percentage increase in the redemption yield of the instrument. The unit of duration is generally measured in years' and ranges between 0 years and the maximum maturity of the bond.
Steps to Calculate Duration:
Coupon rate determination.
Determining PV (Present Value) factor using the yield per period.
Then PV factor is to be multiplied with coupon amount to arrive at the PV value of the coupon payment.
The aggregate of the present value of cash flows is arrived to determine the market value of the bond.
For each year, the percentage of present value in total market is arrived. (step 3 / step 4).
The resultant figure is multiplied with the year and the aggregate amount is the duration.
Factors influencing duration are usually the bond's maturity time and the coupon rate. A bond maturing in 2 years recovers its cost in quicker time as compared to a bond maturing in 10 years. Hence, duration varies as per the maturity, shorter maturity has lower duration and similarly longer maturity has higher duration. Coupon rate also is a key factor in determining the cost recovering period of the bond. A higher coupon bond return the cost in quick time compared to a lower coupon bond. Hence, higher coupon bonds have lower duration and lower coupon bonds have higher duration.
Duration guides investors in choosing the bond as per their risk appetite. Investors seeking quick cost recovery and minimal sensitivity to interest changes can use the concept of duration and also speculators anticipating changes in interest rates can adjust their portfolios.