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Session 5: Duration
A. Duration is the weighted average time for investors to recover the cost of their
investment from the cash flows of the investment. The weight attached to each
cash flow is defined as the present value of the cash flow divided by the cost. The
time attached to each cash flow is defined as the time period when the cash flow
is received.

B.
Answers:
Coupon rate Duration Years to maturity Duration YTM Duration
10% 1.8684 2 1.8684 5 1.8684
12% 1.8473 4 3.4483 7 1.8657
14% 1.8276 6 4.8175 9 1.8630
16% 1.8091 8 6.0257 11 1.8602
18% 1.7918 10 7.1066 13 1.8575
20% 1.7754 12 8.0833 15 1.8547
Relationship between Dur ation & Coupon Rate: 2-year bond with yield of 5%
1.7600
1.7800
1.8000
1.8200
1.8400
1.8600
1.8800
8% 10% 12% 14% 16% 18% 20% 22%
Coupon Rat e
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Relat i ons hip bet w een Dur at ion & Mat ur i t y - 10% coupon bond w i t h yield of 5%
0.0000
2.0000
4.0000
6.0000
8.0000
10.0000
0 2 4 6 8 10 12 14
Year s t o Mat ur i t y
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Relat i ons hip bet w een Dur at ion & Yield - 2-year 10% coupon bond
1.8500
1.8550
1.8600
1.8650
1.8700
3 5 7 9 11 13 15 17
Yi el d t o Mat ur it y
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2
The results and diagrams show that duration is
i) inversely related to coupon rate. The higher the coupon rate, the sooner the
investor will recover the cost of investment and hence the smaller duration.
ii) directly related to maturity. The longer the maturity, the longer it takes to
recover the cost of investment and hence the larger duration.
iii) inversely related to yield to maturity. If you plot a diagram to illustrate the
relationship between the yield and price of a bond, you should realise that the
bond price decreases at a decreasing rate with yield. This relationship implies
that the larger the yield, the lower the price sensitivity of a bond to interest
rate changes. But smaller duration also corresponds to lower bond price
sensitivity. Thus the larger the yield, the smaller the duration.

C. From the session on bond pricing:
As Coupon rate and maturity , price sensitivity .
From the previous question:
As Coupon rate and maturity , duration .
Thus a direct relationship between duration and price sensitivity is expected.

D. Since cash flows in the form of coupon interests are received prior to maturity, the
investor does not need to wait until maturity to recover the cost of investment.
Hence the duration of a coupon bond is generally smaller than its time to
maturity.

E. The duration is 0.5 years since the remaining cash flows (FV and final coupon
interest) are all received six months later when the bond matures and the present
value of the cash flows is equal to the cost of investment. Thus the duration of a
coupon bond is not always smaller than its time to maturity. It can be the same as or less
than the time to maturity.

F. Yes, this investment is risk-free since you are certain of the cost and terminal value of the
investment.

G. Assumption 1: The yield curve is flat at the time of bond investment. This
ensures that the expected return from the bond is the same return as its initial yield
to maturity.

Assumption 2: Any unexpected change in rates applies to the entire spectrum of
maturities, i.e., the yield curve experiences a parallel upward/downward shift.
This ensures that the unexpected rise (fall) in coupon reinvestment income offsets
the unexpected fall (rise) in the selling price of the bond completely.

Assumption 3: Prior to any unexpected change in rates, the bonds duration
matches the intended holding period. Otherwise, price risks will not offset
income risks completely.