Bond duration represents the sensitivity of a bond’s price to changes in interest rates. It is a weighted average of the times until the bond’s cash flows are received. This metric is expressed in years and provides an estimate of the percentage price change for a one-percentage-point change in yield. A higher duration indicates greater price volatility in response to interest rate fluctuations. For instance, a bond with a duration of 5 years is expected to decline in price by approximately 5% if interest rates rise by 1%.
Understanding a debt instrument’s interest rate sensitivity is crucial for managing investment risk. It enables investors to assess the potential impact of interest rate movements on their bond portfolios. Employing this measure allows for informed decisions regarding bond selection and portfolio diversification, ultimately contributing to optimized risk-adjusted returns. Furthermore, its development provided a standardized method to compare the interest rate risk of different bonds, regardless of their coupon rates or maturities.