Benefits of Duration:

Understand Macaulay Duration: Macaulay duration is a measure of the weighted average time it takes to receive cash flows from a bond, taking into account the present value of those cash flows. It provides an estimate of the bond’s price sensitivity to changes in interest rates.
Calculate Macaulay Duration: To calculate the Macaulay duration, follow these steps: a. Identify the cash flows and their respective time periods for the bond. b. Determine the present value of each cash flow by discounting them at the prevailing interest rate. c. Multiply each present value by the respective time period and divide by the bond’s current price. d. Sum up all the weighted present values to calculate the Macaulay duration.
Understand Modified Duration: Modified duration is a measure of the percentage change in the bond’s price for a given change in interest rates. It is derived from Macaulay duration and is a more practical measure for assessing interest rate risk.
Calculate Modified Duration: To calculate the modified duration, use the formula: Modified Duration = Macaulay Duration / (1 + Yield)
The yield represents the current market interest rate or the yield to maturity of the bond.
Interpretation:
- Higher Macaulay duration indicates greater price sensitivity to interest rate changes.
- Higher modified duration suggests greater percentage price change for a given change in interest rates.
Assessing Debt Exposure: Once you have calculated the modified duration, you can assess the organization’s debt exposure to interest rate changes. The higher the modified duration, the greater the organization’s vulnerability to interest rate fluctuations. A higher modified duration implies that a small change in interest rates will have a larger impact on the bond’s price.
Sensitivity Analysis: Perform sensitivity analysis by calculating the estimated change in bond price for a given change in interest rates. You can use the modified duration to estimate the percentage change in the bond price for a specific change in interest rates. For example, if the modified duration is 4 and interest rates increase by 1%, the bond price is estimated to decrease by approximately 4%.