The weighted average time until cash flows are received, expressed in years, serves as a key metric in fixed income analysis. This figure effectively measures a bond’s price sensitivity to changes in interest rates. The computation involves discounting each cash flow (coupon payments and principal repayment) to its present value, weighting each by its proportion of the bond’s total value, and then summing these weighted times. For example, a bond with a value of $1000 that pays annual coupons and matures in three years will have its coupon payments and principal discounted back to the present. These present values are then multiplied by the time until receipt (1 year, 2 years, and 3 years respectively) and summed. The resulting sum, when divided by the bond’s current price, yields the metric.
Understanding the price volatility of a bond portfolio is greatly enhanced through this measure. Its calculation allows investors to compare bonds with different maturities and coupon rates on a standardized scale. This assists in managing interest rate risk, as higher values indicate greater sensitivity to interest rate movements. Historically, this duration concept evolved as a refinement of simple maturity, providing a more accurate assessment of risk in an environment where interest rate fluctuations significantly impact bond values.
