Calculating a Bond's Duration

Calculating a bond’s duration can be a complicated task if you are not mathematically oriented. A key term used in determining the value is its "duration." Duration refers to the length of time until bond maturity in conjunction with the risk associated during that time frame. The higher the bond duration, the more sensitive it is to different changes. To figure out the duration, you need to have some knowledge of the type of bond you purchased and of varying interest rates, and you need a formula or bond calculator.

Type of Bond

There are two different types of bonds available. One is the Zero Coupon Bond, which is a bond whose duration is equal to the time of maturity. Basically, what this means is that the bond will be paid in full when it matures. The difference with a Vanilla Bond is that it pays the bond holder once a year until the bond matures. When the bond matures, the bond holder is paid the final payment, including the face value of the bond. Whichever type of bond you choose, be aware that, although the duration gradually decreases as the bond gets closer and closer to maturity, the duration will increase again momentarily when the bond is paid out or sold.

Interest Rates

The difficulty with interest rates is that they are ever changing, which can be beneficial or detrimental to your bond’s value. If you were to go out and purchase a bond with an interest rate of 3% and then a few days later the interest rate went up to 4%, it would inadvertently decrease the value of your bond. Unfortunately, if you went to sell your bond to someone else, you would be less likely to get the full value of your bond due to the recent increase in interest rates. It is important to know prior to purchasing a bond which ones are more sensitive to this varying relationship so you are aware how much your bond will be affected by changing interest rates.

Duration of a Bond

You can use different methods to figure out a bond’s duration. One method is the Macaulay Duration formula, which can be looked up on the Internet. The Macaulay formula states that duration equals the current value of the bond’s cash flow, weighted by the length of time until receipt and divided by the bond’s current value. This complex formula will help you figure out the duration of your current bond. Make sure you have a calculator handy, as this is a complicated formula for most. Another alternative would be to look up a bond calculator on the Internet. Many financial websites have this calculator available to the public to minimize the difficulty in devising the bond’s worth.

A bond can be a wonderful investment if you are aware that varying interest rates can result in some financial consequences. Being able to determine the duration will help you to make a knowledgeable decision as to whether you want to keep the bond or sell it in order to make future investments.  

blog comments powered by Disqus
Scottrade