Bonds as a financial instrument, duration is their characteristic

Duration (from English duration - "duration") is a financial term that characterizes the weighted average period for receiving payments. It is used to calculate the yield on bonds. In calculating the discounted values of these payment flows are used. If the asset is considered a function of income, duration is a measure of sensitivity to its reduction or an increase in the price level. This double use of the term often creates confusion. Therefore, in this article, we will try to understand the economic significance of this concept, as well as its features.

Definition of term

Strictly speaking, duration is the weighted average period for receiving payment flows. This is what Frederick Macaulay meant by this term when he first introduced it into scientific use. Duration is the average volume of total payments on a security, from today to the end of its repayment. Calculation of this indicator is rational to implement for fixed cash flows. In simple terms, the duration of a bond is equal to the number of years allocated for its repayment, i.e., this value is from zero to the end of the period.

What is the modified duration?

The second meaning of this term is also used in economic usage. In this case duration is a percentage change in prices in response to a decrease or increase in income. This indicator is applied to financial instruments that are sensitive to a change in interest with variable cash flows. It is used more often than Macaulay's duration formula.

Classification of bonds

This type of securities is used along with shares. The bond indicates the depositing of funds by its owner and confirms the issuer's obligation to reimburse them, as well as a certain percentage within a specified period. These securities are often used to cover the budget deficit of the state. Allocate mortgages and unsecured bonds. The first type is more reliable, since in case of non-fulfillment of the reimbursement condition, the issuer loses ownership of its property in favor of the holder of this security. Depending on the term of repayment, allocate short-, medium- and long-term bonds. By the type of the issuer - state, municipal, corporate and foreign. Depending on the order of ownership - registered and bearer. Revocable bonds can be redeemed ahead of time with or without a premium. The right of return allows the holder of securities to obtain their nominal value from the issuer ahead of schedule . Extend and deferred bonds also stand out. The first give the investor the right to continue to receive interest for a certain period of time after the originally set deadline. The latter give the issuer the right to postpone the repayment of his debt.

Application of the concept

In most cases, the indicators of the two types of duration are close, if not equal. And this can be used in making important financial decisions. For example, the duration of a Macaulay bond is approximately 10 years (this is the time for their full repayment). This means that their price sensitivity is about 10%.

Calculation of indicators

The Macaulay duration, or the weighted maturity of the flow of payments, is calculated on the basis of three indicators. Among them:

• PVi - current value of the i-th stream from the asset;
• Ti - the time in years before receiving a certain part of the money;
• V - current value of future receipts from the asset.

The formula in this case is as follows: Σti x PVi: V.

Risks of bonds

The higher the expected return on assets, the greater the loss, if something goes wrong. For players in the financial market, risk is the main source of earnings. The basic and secondary problems associated with bonds are singled out. Credit risk is related to the fact that the issuer can go bankrupt. The state can restructure payments on bonds, as Greece did during the recent default. The second risk is related to the lack of liquidity. This means that when you sell, the price may be less than when you buy. To base also carry the risk which is connected with interest rates. When they increase, the price of bonds goes down. Therefore at this moment it is extremely unprofitable to sell them. Finally, an important risk is the decrease in profitability due to the volatility of exchange rates.

Secondary problems

In addition to the four basic risks, they also allocate additional risks, which also need to be considered when investing in bonds. First of all, they include the problem associated with changing the effective yield. An important factor is the risk of inflation. However, money that is not invested anywhere, depreciates even more in this case. You need to take into account the risk that is associated with the call option. If the bond contains the possibility of its early redemption, then it may suddenly stop giving income. Therefore, you need to carefully read the prospectus. The calculation of the duration gives the investor an idea of the bond's volatility. These indicators are directly proportional. A bond with a longer duration is attractive for speculators. Their strategies are aimed at increasing its liquidity over time.