We are having our annual banking conference this Monday, Tuesday and Wednesday. As such, the article in this section of the publication revisits an educational piece that we ran a few years ago. We will return again on Thursday and Friday of this week with fresh material, but in the meantime, please enjoy this blast from the past as you enjoy your morning coffee.
With college basketball's March Madness nearly upon us, we decided to go back to school for a quick lesson on duration. Duration is the weighted average time to maturity and the price sensitivity of a bond. The weighted average time to maturity of a bond's discounted cash flows is known as Macaulay's Duration.
The basic principle is that two different securities with different maturities and cash flows could have the same price sensitivity for a given a change in rates. If the weighted average time to maturity of the discounted cash flows are the same, their price sensitivities will also be the same.
How is this applicable? Take a 5-year coupon bond that is matched against a 4-year CD that pays interest at maturity. If their Macaulay durations are matched and rates change by a small amount, the value of the liability and the asset will change by the same amount. However, the more rates change, the less accurate it becomes, (i.e. convexity). Furthermore, if 5-year rates change and 7-year rates do not, we encounter the dreaded "non-parallel yield curve shift".
Finally, what if nothing else changes, will this relationship still be the same a month from now? The answer is no; we call this phenomenon duration decay.
The price sensitivity of a bond is correctly referred to as a form of duration as well. This is the measurement that's referred to as modified duration, which gives an approximation of the amount of price changes.
Therefore, if rates rise or fall by 100 basis points, a 5-year coupon bond with a modified duration of 4.0 will fall or rise about 4%. However, the bond will increase in price more for a decrease in rates, than it will lose in price for an increase in rates, (i.e., positive convexity).
While not to get too bogged down in the details, the concept of duration should be understood, calculated or estimated when making any investment.
Whether a banker is looking at securities, loans, CDs or FHLB advances; calculating duration is the first step towards eliminating interest rate risk.