Lesson

Duration measures the sensitivity of a fixed-income security's price to changes in interest rates.

Practice Question #1

Which of the following best describes the relationship between a bond's duration and its interest rate risk?

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Terms

Duration:
A measure of the sensitivity of a bond's price to changes in interest rates.
Interest Rate Risk:
The risk that interest rate changes will negatively impact a bond's value.

Practice Question #2

Which of the following is a strategy used to protect a bond portfolio from interest rate risk by matching the duration of assets and liabilities?

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Historical Example

In the early 1990s, many investors were caught off guard by a sudden rise in interest rates. Those who had invested in long-duration bonds experienced significant losses as the prices of these bonds fell sharply in response to the higher rates.

Practice Question #3

Which of the following measures the curvature of a bond's price-yield relationship?

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Real-World Example

An investor is considering purchasing a 10-year bond with a duration of 7 years. If interest rates rose by 1%, the bond's price would fall by approximately 7%. Conversely, if interest rates were to fall by 1%, the bond's price would rise by about 7%.

Practice Question #4

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More Detail

$ *Duration*: Duration is a measure of the sensitivity of a bond's price to changes in interest rates. It is expressed in years and represents the weighted average time it takes to receive all cash flows from a bond. $ *Duration risk*: Duration risk refers to the potential for a bond's price to change due to fluctuations in interest rates. Bonds with longer durations are more sensitive to interest rate changes, resulting in greater price volatility.

Practice Question #5

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More Detail Examples

$ *Duration*: A bond with a duration of 5 years means that, on average, it takes 5 years to receive all cash flows from the bond. If interest rates rise, the bond's price will decrease more than a bond with a shorter duration. $ *Duration risk*: An investor holding a bond with a long duration faces a higher risk of the bond's price decreasing if interest rates rise. Conversely, if interest rates fall, the bond's price will increase more than a bond with a shorter duration.

Practice Question #6

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Pitfalls to Remember

*Duration risk misconception*:
Duration risk does not mean longer-duration bonds are inherently riskier investments. It simply means that their prices are more sensitive to interest rate changes. Investors should also consider credit and prepayment risk as applicable.

Practice Question #7

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Practice Question #8

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Practice Question #9

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