Bond duration

Duration is a sensitivity measure of bond prices to yield changes. Some duration measures are effective duration, Macaulay duration, and modified duration. The type of duration that we will discuss is modified duration, which measures the percentage change in bond price with respect to a percentage change in yield (typically 1% or 100 basis points (bps)).

The higher the duration of a bond, the more sensitive it is to yield changes. Conversely, the lower the duration of a bond, the less sensitive it is to yield changes.

The modified duration of a bond can be thought of as the first derivative of the relationship between price and yield:

Here:

• dY is the given change in yield
• P⁻ is the price of the bond from a decrease in yield by dY
• P⁺ is the price of the bond from an increase in yield by dY
• P₀ is the initial price of the bond

It should be noted that the...