Duration

Why duration matters

Maturity alone does not capture rate sensitivity because coupon timing and embedded options affect when value is received. Duration lets investors compare bonds, manage portfolio rate exposure, match liabilities, construct hedges, and estimate first-order losses under yield changes. It is also used for spread risk and multi-asset analysis. The specific duration measure must match the instrument, especially when cash flows can change as rates move.

How it is applied

Modified duration is derived from yield-to-maturity cash flows and works for option-free bonds under small parallel yield shifts. Effective duration reprices the instrument after an upward and downward curve shock, allowing modeled cash flows to change. Key-rate duration measures sensitivity at individual curve maturities. Portfolio duration is approximately market-value weighted for ordinary bonds. Managers supplement it with convexity, curve scenarios, spread duration, and cash-flow analysis.

Formula

Portfolio example

A bond portfolio with modified duration of 5 is expected to lose about 2.5% if yields rise 0.50 percentage points, before convexity, spread, and income effects. A duration hedge using futures may offset the parallel government-rate move but leave exposure to credit spreads or particular curve points. For a callable bond, effective duration may shrink as falling rates make redemption more likely.

How to interpret it

Higher positive duration generally means greater price decline when yields rise and greater gain when they fall. A duration of five is not five years to maturity and does not imply a maximum 5% loss. Dollar duration translates sensitivity into currency amounts. Aggregate duration can conceal offsetting curve positions, so key-rate measures and scenarios show where exposure sits. Liability duration matters when judging an institution’s net position.

Limitations and common misconceptions

Duration is a local linear approximation. Large or nonparallel moves require convexity and full revaluation. Credit spreads, currencies, liquidity, and defaults can dominate the rate effect. Option models depend on volatility and borrower behavior. Floating-rate instruments can have low duration but substantial credit risk. Portfolio duration may change after market moves. Investors should disclose methodology and combine the summary with curve, spread, and stress analysis.