Duration Risk: Definition & Examples

Instructor: Douglas Stockbridge

DJ Stockbridge is currently pursuing a Masters degree in Accounting.

In this lesson, we will discuss what duration risk is and how it affects your fixed-income investment portfolio. The lesson will provide the definition of duration risk and then walk through a detailed real-world example.

Your Grandmother Needs Your Help

Imagine that your grandmother pulls you to the side of her living room. She is hosting you and the rest of your family for Thanksgiving. ''You've always been my favorite,'' she starts by saying. Oh no, you think to yourself, she's trying to soften you up. She must need a favor from you. ''You know how I've started to invest my retirement savings.'' Here, it comes, you think to yourself. ''Well,'' she continues, ''I need help with my allocation for bonds. I keep reading in the business section of the newspaper that interest rates may increase and I should be worried about duration risk, as a result. What the heck does this mean? What is duration risk?'' Luckily, because you read this lesson and learned about the topic, you can inform her.

Definition of Duration Risk

Duration risk, also known as interest rate risk, is the possibility that changes in borrowing rates (i.e. interest rates) may reduce or increase the market value of a fixed-income investment. Duration risk is easier to understand through an example, and we'll walk through one below. But in plain English, interest rates may change after you invest in a bond. Say you invest in a bond at 5% interest. If interest rates increase by 1%, additional investors in the same bond will now demand a 6% rate of return. Because the bond interest payments are fixed each year, the market price of the bond will decrease to increase the rate of return from 5% to 6%.

Grandma's Investment

Let's imagine that your grandmother is considering investing $1,000 in a 20-year bond. The coupon rate is 5%, so the amount of cash she will receive each year is $1,000 x 5% = $50. Let's say she invests at par. This means her coupon rate (5%) is equal to the interest rate (5%). Put another way, interest rates are at 5%, meaning investors demand a 5% return to invest in that bond. So, she pays $1,000 for the right to receive $50 every year for the next 20 years, and then in year 20, she will receive her principal of $1,000 back. Let's say the very next day after your grandmother makes the investment, interest rates double to 10%. This means if your grandmother had waited just one more day to make the investment she would have earned 10% each year. The coupon rate would still be 5% on $1,000 par amount, so the cash payments she receives would still be $50 each year, but instead of paying $1,000 at the beginning, she would have paid significantly less. In fact, she would have paid roughly $500. Her annual expected return would have been $50/$500 = 10%, much higher than $50/$1,000 = 5%.

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