duration - Finance 254 Duration and Interest Rate Risk...

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Duration and Interest Rate Risk Duration is often described as the effective maturity of an asset. In general, the maturity date of an asset is not a good indication of the longevity of that asset because it does not consider how much of the value is paid before maturity, and how much is paid at maturity. This is an important distinction because the later a cash flow occurs, the more sensitive its present value will be to changes in interest rates. If much of the asset’s value is given by cash flows that occur before maturity, then the price of this asset will be less sensitive to interest rates if compared to receiving its total value at maturity. Duration gives us an indication of the effective maturity, and so provides a better description of the sensitivity of prices with respect to interest rates. A subtle point : Many times people in this class say something like “…bond 1 has more interest rate risk because it has a longer maturity…” This is not entirely correct. What is correct is that bond 1 has more interest rate risk
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