expected life of a fixed-income security, taking into account its coupon yield, interest payments, maturity, and call features. Duration attempts to measure actual maturity, as opposed to final maturity, by measuring the average time required to collect all payments of principal and interest. The duration of a callable bond, also called its effective duration, may be considerably shorter than its stated maturity in a period of rising interest rates. Thus, as market interest rates rise, the duration of a financial instrument decreases. For example, a 30-year conventional mortgage may have an effective duration of only 11 to 12 years, which means the loan will probably be paid off in about one-third of the time it is supposedly carried by the originating lender as an earning asset. Duration differs from other measurements such as average life and half life. Duration measures the time required to recover a dollar of price in present value terms (including principal and interest), whereas average life computes the average time needed to collect one dollar of principal.
concept first developed by Frederick Macaulay in 1938 that measures bond price volatility by measuring the "length" of a bond. It is a weighted-average term-to-maturity of the bond's cash flows, the weights being the present value of each cash flow as a percentage of the bond's full price. A Salomon Smith Barney study compared it to a series of tin cans equally spaced on a seesaw. The size of each can represents the cash flow due, the contents of each can represent the present values of those cash flows, and the intervals between them represent the payment periods. Duration is the distance to the fulcrum that would balance the seesaw. The duration of a zero-coupon security would thus equal its maturity because all the cash flows-all the weights-are at the other end of the seesaw. The greater the duration of a bond, the greater its percentage volatility. In general, duration rises with maturity, falls with the frequency of coupon payments, and falls as the yield rises (the higher yield reduces the present values of the cash flows.) Duration (the term modified duration is used in the strict sense because of modifications to Macaulay's formulation) as a measure of percentage of volatility is valid only for small changes in yield. For working purposes, duration can be defined as the approximate percentage change in price for a 100-basis-point change in yield. A duration of 5, for example, means the price of the bond will change by approximately 5% for a 100-basis point change in yield.
When the durations of the assets and the liabilities of a portfolio, say that of a pension fund, are the same, the portfolio is inherently protected against interest-rate changes and you have what is called immunization. The high volatility and interest rates in the early 1980s caused institutional investors to use duration and convexity as tools in immunizing their portfolios.
