Duration (from English duration - “duration”) is a financial term that characterizes the average weighted term for receiving payments. It is used to calculate bond income. In the calculation, the discounted values of these payment flows are used. If an asset is considered a function of income, then duration is a measure of sensitivity to its decrease or increase in the price level. Such a double use of the term often causes confusion. Therefore, in this article we will try to understand the economic significance of this concept, as well as its features.
Definition of the term
Strictly speaking, duration is the weighted average term for receiving payment flows. It was this meaning that Frederick Macaulay meant when he first introduced it into scientific use. Duration is the average amount of total payments on a security, starting from today until the end of its repayment. The calculation of this indicator is rational for fixed cash flows. In simple terms, the duration of a bond is equal to the number of years allotted for its redemption, that is, this value is from zero to the end of the term.
What is a modified duration?
The second meaning of this term is also used in economic everyday life. In this case, duration is a percentage change in prices in response to a decrease or increase in income. This indicator is applied to financial instruments that are sensitive to changes in interest with variable cash flows. It is used more often than the Macaulay duration formula.
Bonds classification
This type of securities is used along with stocks. The bond indicates that the owner has paid the funds and confirms the issuer's obligation to reimburse them, as well as a certain percentage on time. These securities are often used to cover the state budget deficit . Allocate mortgages and unsecured bonds. The first type is more reliable, since in case of non-fulfillment of the conditions for reimbursement of funds, the issuer loses ownership of its property in favor of the holder of this security. Depending on the term of repayment, short, medium and long-term bonds are distinguished. By type of issuer - state, municipal, corporate and foreign. Depending on the order of ownership - registered and bearer. Revocable bonds may be redeemed ahead of schedule with or without a premium. The right of return allows the holder of securities to receive their nominal value from the issuer ahead of schedule . There are also extended and deferred bonds. The former gives the investor the right to continue to receive interest for a certain time after the originally set deadline. The latter give the issuer the right to postpone the repayment of its debt.
Application concept
In most cases, the indicators of the two types of duration are close, if not equal. And this can be used in making important financial decisions. For example, Macaulay bond duration is approximately 10 years (such is the period for their full repayment). This means that their price sensitivity is about 10%.
Calculation of indicators
Macaulay duration, or the weighted time period for receipt of payment flows, is calculated based on three indicators. Among them:
- PVi is the current value of the i-th stream from the asset;
- ti - time in years before receiving a certain part of the money;
- V is the current value of future earnings from the asset.
The formula in this case is as follows: ∑ti x PVi: V.
Bond risks
The higher the estimated return on assets, the greater the amount of loss if something goes wrong. For players in the financial market, risk is the main source of income. Basic and secondary issues related to bonds are highlighted. Credit risk is associated with the fact that the issuer may go bankrupt. The state may restructure bond payments, as Greece did during a recent default. The second risk is associated with a lack of liquidity. This means that when selling, the price may be less than when buying. The basic ones also include the risk associated with interest rates. With their increase, bond prices go down. Therefore, at this moment it is extremely unprofitable to sell them. Finally, the risk of declining returns due to the volatility of exchange rates is important.
Minor issues
In addition to the four basic risks, there are also additional ones that should also be considered when investing in bonds. First of all, they include the problem associated with the change in effective profitability. The risk of inflation is also important. However, money that is not invested anywhere depreciates in this case even more. You need to take into account the risk associated with the call option. If the bond includes the possibility of its early redemption, then it may unexpectedly stop giving income. Therefore, you need to carefully read the prospectus. The calculation of duration gives the investor an idea of the volatility of the bond. These indicators are directly proportional. A bond with a longer duration is attractive to speculators. Their strategies are aimed at increasing its liquidity over time.