10.c Duration Defined

Overview of Duration and Investment Strategies

Introduction to Duration
- Duration measures the sensitivity of a bond's price to changes in interest rates.
- Analogous to Beta (for stocks) and Delta (for options) as measures of relative movement.

Investment Horizon
- Defined as the time until the funds will be needed (e.g., child's college in five years).
- Investing time periods significantly affect risk.
Reinvestment Risk
- Occurs when investing in short-term securities, such as a 1-Year T-bill.
- Example:
  - If the interest rate is 3%, reinvestment in a lower interest scenario results in decreased returns.
- Higher risks arise when interest rates drop after rolling over investments.
Price Risk
- Arises when investing in longer-term securities, such as a 10-Year Bond.
- Selling a bond before maturity results in a price influenced by market interest rates; a rate hike increases risk of receiving a lower price.

Equal Maturity and Horizon
- Investing in a 5-Year Bond aligns maturity with the investment horizon.
- This approach is known as 'immunization.'
- Reduces risks associated with fluctuating interest rates, ensuring bonds mature just when money is needed.
Zero-Coupon Bonds
- Investment in zero-coupon bonds for five years eliminates reinvestment risk due to direct cash flow at maturity.

Duration as Cash Flow Measurement
- Defined as a weighted average of when cash flows are received.

Duration Equals Maturity
For zero-coupon bonds, all cash flows are concentrated at maturity, hence duration matches maturity.

Duration Less Than Maturity
The presence of interim coupon payments makes the duration of coupon bonds shorter than their maturity.
The more frequent or larger the coupon payments, the lower the duration compared to maturity.

Upcoming content will delve into the calculations of duration using practical examples to solidify understanding.