What is Duration Formula?
The formula for the duration is a measure of a bond’s sensitivity to changes in interest rate and it is calculated by dividing the sum product of discounted future cash inflow of the bond and a corresponding number of years by a sum of the discounted future cash inflow. The cash inflow basically comprises of coupon payment and the maturity at the end. It is also known as Macaulay duration.
Mathematically, the equation for the duration is represented as below,
where,
- C = Coupon payment per period
- M= Face or Par value
- r =Effective periodic rate of interest
- n = Number of periods to maturity
Further, the denominator which is the summation of the discounted cash inflow of the bond is equivalent to the present value or price of the bond. Therefore, the formula for the duration can be further simplified as below,
Explanation of the Duration Formula
The equation for the duration can be computed by using the following steps:
Step 1: Firstly, the face or par value of the bond issuance is figured out and it is denoted by M.
Step 2: Now, the coupon payment of the bond is calculated based on the effective periodic rate of the interest. Then the frequency of the coupon payment is also determined. The coupon payment is denoted by C and the effective periodic rate of interest is denoted by r.
Step 3: Now, the total number of periods till maturity is computed by multiplying the number of years till maturity and the frequency of the coupon payments in a year. The number of periods till maturity is denoted by n. Also, the time of the periodic payment is noted which is denoted by i.
Step 4: Finally, based on the available information the equation for the duration can be derived as below,
Examples of Duration Formula (with Excel Template)
Let’s see some simple to advanced types of duration formula to understand it better.
Duration Formula Formula – Example #1
Let us take an example of a bond with annual coupon payments. Let us assume that company XYZ Ltd has issued a bond having the face value of $100,000 carrying an annual coupon rate of 7% and maturing in 5 years. The prevailing market rate of interest is 10%.
Given, M = $100,000
- C = 7% * $100,000 = $7,000
- n = 5
- r = 10%
The denominator or the price of the bond is calculated using the formula as,
- Bond price = 84,281.19
Calculation of the numerator of Duration formula is as follows –
= (6,363.64 + 11,570.25 + 15,777.61 + 19,124.38 + 310,460.70)
= 363,296.50
Therefore, the calculation of duration of the bond will be as below,
Duration = 363,296.50 / 84,281.19
- Duration =4.31 years
Duration Formula Formula – Example #2
Let us take an example of a bond with annual coupon payments. Let us assume that company XYZ Ltd has issued a bond having face value of $100,000 and maturing in 4 years. The prevailing market rate of interest is 10%. Calculate the bond duration for the following annual coupon rate: (a) 8% (b) 6% (c) 4%
Given, M = $100,000
- n = 4
- r = 10%
Calculation for Coupon Rate of 8%
Coupon payment (C)= 8% * $100,000 = $8,000
The denominator or the price of the bond is calculated using the formula as,
- Bond price = 88,196.16
Calculation of the numerator of the Duration formula will be as follows –
= 311,732.81
Therefore, the calculation of duration of the bond will be as below,
Duration = 311,732.81/ 88,196.16
- Duration = 3.53 years
Calculation for Coupon Rate of 6%
Coupon payment (C) = 6% * $100,000 = $6,000
The denominator or the price of the bond is calculated using the formula as,
- Bond price = 83,222.46
Calculation of the numerator of the Duration formula will be as follows –
= 302,100.95
Therefore, the calculation of duration of the bond will be as below,
Duration = 302,100.95 / 83,222.46
- Duration = 63 years
Calculation for Coupon Rate of 4%
Coupon payment = 4% * $100,000 = $4,000
The denominator or the price of the bond is calculated using the formula as,
- Bond price = 78,248.75
Calculation of the numerator of the Duration formula will be as follows –
= 292,469.09
Therefore, the calculation of duration of the bond will be as below,
Duration Formula = 292,469.09 / 78,248.75
- Duration = 3.74 years
From the example, it can be seen that the duration of a bond increases with the decrease in coupon rate.
Relevance and Use of Duration Formula
It is important to understand the concept of duration as it is used by bond investors to check a bond’s sensitivity to changes in interest rates. The duration of a bond basically indicates how much the market price of a bond will change owing to the change in the rate of interest. It is noteworthy to remember that rate of interest and bond price move in opposite directions and as such bond price rise when the rate of interest falls and vice versa.
In case investors are seeking benefit from fall in interest rate, the investors will intend to buy bonds with a longer duration which is possible in case of bonds with lower coupon payment and long maturity. On the other hand, investors who want to avoid the volatility in interest rate, the investors will be required to invest in bonds that have a lower duration or short maturity and higher coupon payment.
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