Relationship between coupon rate and duration

Duration - Full Explanation & Example | InvestingAnswers

relationship between coupon rate and duration

That said, the maturity date of a bond is one of the key components in figuring duration, as is the bond's coupon rate. In the case of a zero-coupon bond, the. Thanks for the A2A. All the bonds have coupon interest rate, sometimes also referred to as coupon rate or simply coupon, that is the fixed annual interest paid by. calculation of the change in bond prices given varying coupon payment Duration assumes a linear relationship between bond prices and changes in.

Investment professionals rely on duration because it rolls up several bond characteristics such as maturity date, coupon payments, etc.

relationship between coupon rate and duration

Duration is expressed in terms of years, but it is not the same thing as a bond's maturity date. That said, the maturity date of a bond is one of the key components in figuring duration, as is the bond's coupon rate. In the case of a zero-coupon bond, the bond's remaining time to its maturity date is equal to its duration.

When a coupon is added to the bond, however, the bond's duration number will always be less than the maturity date. The larger the coupon, the shorter the duration number becomes.

relationship between coupon rate and duration

Generally, bonds with long maturities and low coupons have the longest durations. These bonds are more sensitive to a change in market interest rates and thus are more volatile in a changing rate environment.

coupon rate vs. duration

Conversely, bonds with shorter maturity dates or higher coupons will have shorter durations. Bonds with shorter durations are less sensitive to changing rates and thus are less volatile in a changing rate environment. Why is this so? Because bonds with shorter maturities return investors' principal more quickly than long-term bonds do. Therefore, they carry less long-term risk because the principal is returned, and can be reinvested, earlier.

relationship between coupon rate and duration

This hypothetical example is an approximation that ignores the impact of convexity; we assume the duration for the 6-month bonds and year bonds in this example to be 0. Duration measures the percentage change in price with respect to a change in yield.

The Relationship Between Bonds and Interest Rates

FMRCo Of course, duration works both ways. If interest rates were to fall, the value of a bond with a longer duration would rise more than a bond with a shorter duration. Using a bond's convexity to gauge interest rate risk Keep in mind that while duration may provide a good estimate of the potential price impact of small and sudden changes in interest rates, it may be less effective for assessing the impact of large changes in rates.

This is because the relationship between bond prices and bond yields is not linear but convex—it follows the line "Yield 2" in the diagram below. This differential between the linear duration measure and the actual price change is a measure of convexity—shown in the diagram as the space between the blue line Yield 1 and the red line Yield 2. Relationship between price and yield in a hypothetical bond The impact of convexity is also more pronounced in long-duration bonds with small coupons—something known as "positive convexity," meaning it will act to reinforce or magnify the price volatility measure indicated by duration as discussed earlier.

The Relationship Between Bonds and Interest Rates- Wells Fargo Funds

Keep in mind that duration is just one consideration when assessing risks related to your fixed income portfolio. Credit risk, inflation risk, liquidity risk, and call risk are other relevant variables that should be part of your overall analysis and research when choosing your investments.

What does Coupon Rate mean?

The higher the bond's duration, the greater its sensitivity to the change also know as volatility and vice versa. How it works Example: There is more than one way to calculate duration, depending on one's compounding assumptions, but the Macaulay duration named after Frederick Macaulay, an economist who developed the concept in is the most common.

Duration: Understanding the Relationship Between Bond Prices and Interest Rates - Fidelity

By multiplying a bond's duration by the change, the investor can estimate the percentage price change for the bond. For example, consider the Company XYZ bonds with a duration of 5.

If for whatever reason market yields increased by 20 basis points 0.

relationship between coupon rate and duration

The formula assumes a linear relationship between bond prices and yields even though the relationship is actually convex. Thus, the formula is less reliable when there is a large change in yield. In general, six things affect a bond's duration: The higher a bond's coupon, the more income it produces early on and thus the shorter its duration. The lower the coupon, the longer the duration and volatility.

relationship between coupon rate and duration