Stocks and Bond Valuation Concepts Flashcards
a measure that helps investors understand how sensitive a bond’s price is to changes in interest rates. Think of it as a tool to gauge the risk associated with fluctuations in the financial environment.
Duration.
Definition: The weighted average time until a bond’s cash flows (interest and principal) are received.
Purpose: Helps in understanding the time aspect of a bond investment.
Macaulay Duration
measures the price sensitivity of a bond to interest rate changes.
Usage: Estimates the percentage change in bond price for a 1% change in interest rates.
Modified duration
Formula: Modified Duration = Macaulay Duration / (1 + Yield/Number of Periods)
The longer a bond investment’s duration, the more sensitive the investment is to changes in interest rates.
Duration gives us a measure of the approximate price volatility for bonds given a change in interest rates.
As such, it is a measure of interest rate risk. For example, if a bond has a duration of four and interest rates were to rise 1%, the bond would then decline in price about 4%.
If a bond has a duration of nine and interest rates were to fall 1%, the bond would rise in price about 9%.
Remember.
Although interest rate risk is a factor when purchasing individual bonds, the investor can always hold until maturity period. However, this is not the case if the investor has a bond fund because the fund itself does not mature.
This is one example of why holding individual bonds Reassure the investor that, as long as they hold it until maturity. They will receive their principal and the stated interest.
Bond funds, by comparison, offer no such safety of principle.
Each column on top of the seesaw in Figure 4.7 represents the present value of the cash flow to the investor. The small columns are the present values of the semiannual interest payments, and the larger column at the right end is the present value of the $1,000 par value of the bond plus the final semiannual coupon payment.
