Relationship between YTM vs. Duration | AnalystForum
I've been talking to a lot of investors about how to prepare a portfolio for rising rates lately, and the same buzzwords keep popping up in these. Duration is a measure of a bond's sensitivity to interest rate changes. The formula assumes a linear relationship between bond prices and yields even though [Use our Yield to Maturity (YTM) Calculator to measure your annual return if you. Can someone refresh my memory and simply explain the relationship between YTM and Duration? I realize that higher coupons mean a lower duration, but what is usually the relationship between the lower coupons and YTM? The Macaulay duration is the weighted average term to maturity of.
Duration is a measure of a bond 's sensitivity to interest rate changes.
The higher the bond's duration, the greater its sensitivity to the change also know as volatility and vice versa. How it works Example: There is more than one way to calculate duration, depending on one's compounding assumptions, but the Macaulay duration named after Frederick Macaulay, an economist who developed the concept in is the most common.
By multiplying a bond's duration by the change, the investor can estimate the percentage price change for the bond. For example, consider the Company XYZ bonds with a duration of 5.
If for whatever reason market yields increased by 20 basis points 0. The formula assumes a linear relationship between bond prices and yields even though the relationship is actually convex.
Duration vs. Maturity and Why the Difference Matters
Thus, the formula is less reliable when there is a large change in yield. In general, six things affect a bond's duration: The higher a bond's coupon, the more income it produces early on and thus the shorter its duration. Original Face or Par Value F 3. Price bond was purchased P 4. The Yield to Maturity is 7.
Other than a few reasons that would cause a bond to end its existence prior to maturity, the life span of a bond tells an investor how long the bond may be exposed to risk — the primary one being the erosion of its value purchasing power when inflation is present higher bond price, and a lower return than the coupon rate as in example 2 on YTM. Complexity increases in the details of various ways duration is calculated.
Relationship between YTM vs. Duration
We will quickly outline the calculations but then then circle back and focus on the broader concept and why investors look at duration in conjunction with maturity. Macaulay duration, modified duration and effective duration are three types of duration calculations. Investors will more than likely run across effective duration numbers. Despite the fancy math of the different versions, duration is more of a concept and not a tool to measure an exact expected price change of the bond when interest rates change.
An Introduction to Duration
An example should drive the concept home. Keep in mind the image of a see-saw on a playground conveying the idea that when interest rates go up, bond prices go down and the opposite is true. As noted earlier, duration is more of a concept that estimates the impact to the bond when interest rates change. Ultimately, market participants determine price, but keep in mind market participants would probably be using models to calculate duration in an attempt to determine supply selling and demand buying.
You may have noticed the duration example had the term listed as years. That is the norm used to note duration and also the probable reason why it is can be easily confused with maturity.
Recall that the formula s for duration measured how long it took for the cash flows to repay the initial investment.
Now, the bottom line of the bottom line. Two bonds may have the same maturities, but their sensitivity to interest rate changes may be different. Investors and portfolio managers not only can diversify holdings in regards to when the holdings may expire or mature, but now can diversify holdings in regards to the possible volatility or impacts to bond price movements as interest rates change.
Take high yield bonds for example — according to the iShares website www.
The bonds within these portfolios have, on average, a relatively similar period of time until the principal is assumed to be paid as shown by the average maturities.
However, high yield bonds are implied to have greater insulation to changes in interest rates versus the year Treasuries.FRM Part I-Relationship between Spot Rates, Forward Rates and YTM
Floating rate, as the name implies, has the characteristic of periodically adjusting their interest rate payouts making them even less susceptible to rate changes than the other two.