Duration measures a bond's sensitivity to interest rate changes. It represents the weighted average time to receive all cash flows (coupons + principal) — but more practically, it tells you how much a bond's price will change for a 1% change in interest rates.
Types: - Macaulay duration: Weighted average time to receive cash flows, in years. - Modified duration: Best measure of price sensitivity. Formula: Macaulay Duration ÷ (1 + YTM). - Effective duration: Used for bonds with embedded options (callable bonds, MBS); accounts for cash flow changes as rates change.
The rule: For a 1% increase in interest rates, a bond's price falls approximately by its modified duration percentage.
Example: Modified duration = 7. If rates rise 1%, price falls approximately 7%.
Factors affecting duration: - Longer maturity → higher duration (more sensitive to rates). - Lower coupon → higher duration (more weight on distant principal payment). - Lower YTM → higher duration. - Zero-coupon bond: Macaulay duration = maturity (longest possible duration for a given maturity).
Convexity adjustment: Duration is a linear approximation; actual bond price-yield relationship is convex. Convexity adds accuracy for large rate changes.
> Exam tip: Duration is tested heavily on the Series 7, Series 65/66, and CFP®. Key relationships: longer maturity = higher duration = more interest rate risk; zero-coupon bond = duration equals maturity. "Inverse relationship" — duration and price move in opposite directions to rates.