In finance, the duration of a financial asset, specifically a bond, is a measure of the sensitivity of the asset's price to interest rate movements. It broadly corresponds to the length of time before the asset is due to be repaid. There are various definitions of duration and derived quantities, discussed below. However if not otherwise qualified, "duration" generally means the Macaulay duration, as defined below.
This duration is equal to the ratio of the percentage reduction in the bond's price to the percentage increase in the redemption yield of the bond (or vice versa). This equation is valid for small changes in those quantities only. Duration is known in the context of the "Greeks" used for derivative pricing as the λ or Lambda. In contrast, the absolute change in a bond's price with respect to interest rate (Δ or Delta) is referred to as the dollar duration.
The units of duration are years, and duration is always^{[note 1]} between 0 years and the time to maturity of the bond. It is equal to the time to maturity if and only if the bond is a zerocoupon bond.
One way to follow this is that the value of more distant cash flows is more sensitive to the interest rate, or yield: when calculating the present value of the cash flows under a bond, one divides each future cash flow by the (yield plus one) to the power of the number of years until that cash flow occurs: (1 + y) ^{− n} – thus the present value of more distant future cash flows is more sensitive to changes in yield.
Duration is useful as a measure of the sensitivity of a bond's market price to interest rate (i.e., yield) movements. It is approximately equal to the percentage change in price for a given change in yield. For example, for small interest rate changes, the duration is the approximate percentage by which the value of the bond will fall for a 1% per annum increase in market interest rate. So a 15year bond with a duration of 7 would fall approximately 7% in value if the interest rate increased by 1% per annum. ^{[1]}
(It is important to note that in reality the yield at any one time is not the same for all bonds: it is generally different for different durations, so one cannot refer just to "the yield".)
The standard definition of duration is Macaulay duration, the PVweighted time to receive each cash flow, defined as:
where:
and
A more naïve definition would be to weight by the size of cash flows, not the present value, but, as Macaulay discusses, this does not provide a good measure of the sensitivity to changes in interest rates.
Both these definitions give a weighted average (weights sum to 1) of time to receive cash flows, and thus fall between 0 (the minimum time), or more precisely t(1) (the time to the first payment) and the time to maturity of the bond (the maximum time), with equality if and only if the bond only has a single payment at maturity (i.e., if it is a zerocoupon bond. In symbols, if cash flows are in order:
with the inequalities being strict unless it has a single cash flow.
As stated above, the duration is the weighted average term to payment of the cash flows on a bond. For a zerocoupon bond, the duration will be ΔT = T_{f} − T_{0}, where T_{f} is the maturity date and T_{0} is the starting date of the bond. If there are additional cash flows C_{i} at times T_{i}, the duration of every cash flow is ΔT_{i} = T_{i} − T_{0}. From the current market price of the bond V, one can calculate the yield to maturity of the bond r using the formula
Note that in this and subsequent formulae, the symbol r is used for the force of interest, i.e. the logarithm of (1+j) where j is the interest yield expressed as an annual effective yield.
In a standard duration calculation, the overall yield of the bond is used to discount each cash flow leading to this expression in which the sum of the weights is 1:
The higher the coupon rate of a bond, the shorter the duration (if the term of the bond is kept constant). Duration is always less than or equal to the overall life (to maturity) of the bond. Only a zero coupon bond (a bond with no coupons) will have duration equal to the maturity.
Duration indicates also how much the value V of the bond changes in relation to a small change of the rate of the bond. We see that
so that for a small variation in the redemption yield of the bond we have
That means that the duration gives the negative of the relative variation of the value of a bond with respect to a variation in the redemption yield on the bond, forgetting the quadratic and higherorder terms. The quadratic terms are taken into account in the convexity.
As we have seen above, r = ln(1 + j).
If (which could be defined as the Modified Duration) is required, then it is given by:
and this relationship holds good whatever the frequency of convertibility of j.
The dollar duration is defined as the product of the duration and the price (value): it is the change in price in dollars, not in percentage, and has units of DollarYears (Dollars times Years). It gives the dollar variation in a bond's value for a small variation in the yield.
Dollar duration D_{$} is commonly used for VaR (ValueatRisk) calculation. If V = V(r) denotes the value of a security depending on the interest rate r, dollar duration can be defined as
To illustrate applications to portfolio risk management, consider a portfolio of securities dependent on the interest rates as risk factors, and let
denote the value of such portfolio. Then the exposure vector has components
Accordingly, the change in value of the portfolio can be approximated as
that is, a component that is linear in the interest rate changes plus an error term which is at least quadratic. This formula can be used to calculate the VaR of the portfolio by ignoring higher order terms. Typically cubic or higher terms are truncated. Quadratic terms, when included, can be expressed in terms of (multivariate) bond convexity. One can make assumptions about the joint distribution of the interest rates and then calculate VaR by Monte Carlo simulation or, in some special cases (e.g., Gaussian distribution assuming a linear approximation), even analytically. The formula can also be used to calculate the DV01 of the portfolio (cf. below) and it can be generalized to include risk factors beyond interest rates.
Macaulay duration, named for Frederick Macaulay who introduced the concept, is the weighted average maturity of a bond where the weights are the relative discounted cash flows in each period.
It will be seen that this is the same formula for the duration as given above.
Macaulay showed that an unweighted average maturity is not useful in predicting interest rate risk. He gave two alternative measures that are useful:
The key difference between the two is that the MacaulayWeil duration allows for the possibility of a sloping yield curve, whereas the algebra above is based on a constant value of r, the yield, not varying by term to payment.
With the use of computers, both forms may be calculated, but the Macaulay duration is still widely used.
In case of continuously compounded yield the Macaulay duration coincides with the opposite of the partial derivative of the price of the bond with respect to the yield—as shown above. In case of yearly compounded yield, the modified duration coincides with the latter.
In case of n times compounded yield, the relation
is not valid anymore. That is why the modified duration D ^{*} is used instead:
where r is the yield to maturity of the bond, and n is the number of cashflows per year.
Let us prove that the relation
is valid. We will analyze the particular case n = 1. The value (price) of the bond is
where i is the number of years to the cash flow C_{i}. The duration, defined as the weighted average maturity, is then
The derivative of V with respect to r is:
multiplying by we obtain
or
from which we can deduce the formula
which is valid for yearly compounded yield.
For bonds that have embedded options, such as puttable and callable bonds, Macaulay duration will not correctly approximate the price move for a change in yield.
In order to price such bonds, one must use option pricing to determine the value of the bond, and then one can compute its delta (and hence its lambda), which is the duration. The effective duration is a discrete approximation to this latter, and depends on an option pricing model.
Consider a bond with an embedded put option. As an example, a $1,000 bond that can be redeemed by the holder at par at any time before the bond's maturity (i.e. an American put option). No matter how high interest rates become, the price of the bond will never go below $1,000 (ignoring counterparty risk). This bond's price sensitivity to interest rate changes is different from a nonputtable bond with otherwise identical cashflows. Bonds that have embedded options can be analyzed using "effective duration". Effective duration is a discrete approximation of the slope of the bond's value as a function of the interest rate.
where Δ y is the amount that yield changes, and
are the values that the bond will take if the yield falls by y or rises by y, respectively. However this value will vary depending on the value used for Δ y.
Sensitivity of a bond's market price to a change in Option Adjusted Spread (OAS). Thus the index, or underlying yield curve, remains unchanged.
The sensitivity of a portfolio of bonds such as a bond mutual fund to changes in interest rates can also be important. The average duration of the bonds in the portfolio is often reported. The duration of a portfolio equals the weighted average maturity of all of the cash flows in the portfolio. If each bond has the same yield to maturity, this equals the weighted average of the portfolio's bond's durations. Otherwise the weighted average of the bond's durations is just a good approximation, but it can still be used to infer how the value of the portfolio would change in response to changes in interest rates.
FV = par value
C = coupon payment per period (halfyear)
i = discount rate per period (halfyear)
a = fraction of a period remaining until next coupon
payment
m = number of coupon dates until maturity
P = bond price (present value of cash flows discounted
with rate i)
Duration is a linear measure of how the price of a bond changes in response to interest rate changes. As interest rates change, the price does not change linearly, but rather is a convex function of interest rates. Convexity is a measure of the curvature of how the price of a bond changes as the interest rate changes. Specifically, duration can be formulated as the first derivative of the price function of the bond with respect to the interest rate in question, and the convexity as the second derivative.
Convexity also gives an idea of the spread of future cashflows. (Just as the duration gives the discounted mean term, so convexity can be used to calculate the discounted standard deviation, say, of return.)
Note that convexity can be both positive and negative. A bond with positive convexity will not have any call features  ie the issuer must redeem the bond at maturity  which means that as rates fall, its price will rise.
On the other hand, a bond with call features  ie where the issuer can redeem the bond early  is deemed to have negative convexity, which is to say its price should fall as rates fall. This is because the issuer can redeem the old bond at a high coupon and reissue a new bond at a lower rate, thus providing the issuer with valuable optionality.
Mortgagebacked securities (passthrough mortgage principal prepayments) with USstyle 15 or 30 year fixed rate mortgages as collateral are examples of callable bonds.
PV01 is the present value impact of 1 basis point move in an interest rate. It is often used as a price alternative to duration (a time measure). When the PV01 is in USD, it is the same as DV01 (Dollar Value of 1 basis point).
Duration, in addition to having several definitions, is often confused with other notions, particularly various properties of bonds that are measured in years.
Duration is sometimes explained inaccurately as being a measurement of how long, in years, it takes for the price of a bond to be repaid by its internal cash flows.^{[note 2]} This quantity is the duration of a perpetual bond (assuming a flat yield curve at the coupon), and is simply or the tenor, whichever is shorter. For instance, if a bond pays 5% per annum and was issued at par, it will take 20 years of these payments to repay its price. Note the absurdity of interpreting duration this way: given a bond paying 5% per annum with a tenor of 5 years, the duration is approximately 4.37, whereas the price of the bond will not be repaid in full until maturity (at 5 years).
The WeightedAverage Life is the weighted average of the principal repayments of an amortizing loan, and is longer than the duration.

