International Journal of Economic Perspectives, 2012, Volume 6, Issue 4, 46-56.

Properties and Limitations of Duration as a Measure of Time

Structure of Bond and Interest Rate Risk

Moh'd M. AJLOUNI, Ph.D

Yarmouk University, JORDAN, email: ajlouni4@yahoo.co.uk.

ABSTRACT

The purpose of this study is to examine the main features of duration as a measure of, both, time structure of a
bond and interest rate risk. The study concludes that, as a measure of the time structure of a bond, duration has
four properties: (1) the duration of a bond is always equal or less than its maturity. (2) For a zero coupon bond,
duration equals its maturity. (3) The duration increases as the maturity increase then decreases in nonlinear steps
to reach zero at the final maturity date. (4) As maturity increases, the duration tends to be closed to the perpetuity
duration. In addition, duration measures the elasticity of the market price of an asset (liability) with respect to the
market discount rate. Finally, as a measure of bond's interest rate risk, duration has three features: (1) Duration of
a bond decreases as the coupon rates rises. (2) Duration decreases as the yield to maturity rises. (3) Duration
represents an accurate measure of interest rate elasticity of the bond price. There are, however, many limitations
to duration as a measure of the risk of a bond portfolio.

JEL Classification: G12.

Key Words: Duration; Bonds; Interest Rate; Risk.

1. INTRODUCTION

The concept of duration discovered by Frederick Macaulay (1938) while searching for a correct measure of the
life of a bond. He proposed a measure of duration to represent the "essence of the time element of a loan". Hicks
(1939), independently, derived the equivalent average period measuring bond price elasticity with respect to a
discount rate. In recent years, duration revived and has become an increasingly common technique of fixed
income securities for matching portfolios and as a mean to estimate the volatility or sensitivity of the portfolio's
market value to changes in interest rates (Altman and Nammacher, 1987).

Many characteristics, usefulness, and limitations of duration as an immunization tool, for non zero price assets,
have been reviewed by Bierwag, Kaufman and Khang (1978) and Ingersoll, Skelton, and Weil (1978).
Nevertheless, this essay will discuss the main features of duration as a measure of, both, the time structure of a
bond and the interest rate risk.

Duration measures have been widely promoted as a technique that investors can use to improve their investment
performance. This essay starts with a brief survey of the literature of duration, with focus on the main areas that
duration have been used and introduced.

To examine how duration measures the time structure of a bond and the interest rate risk, the second part of the
essay represents the main measures of duration. This includes definitions, derivations, illustration and
modifications. Through this context, duration's properties are defined and examined.

Since duration measures interest rate risk, it is, then, worthwhile to examine how duration used in immunizing
bond/bonds against such risk. The third part of the essay examines immunizing in two cases: First, in case of a
single payment liability, second, in case of multi payment liability.

However, there are many limitations in using duration technique to estimate bond's risk. Part four defines four of
these limitations. Finally, this essay will be concluded. In the conclusion, the context will not be repeated.
Instead, the core of this essay will be stated.

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2. BRIEF SURVEY OF DURATION LITERATURE

Since the late of 1930s, when Macaulay and Hicks developed the concept of duration, a rich and developing
literature has appeared. Consequently, duration has become an important technique in controlling the maturity
structure of bond portfolios. It has been developed for different uses. These include measurement of basis risk
(Cox, Ingersoll and Ross, 1979), portfolio management (Langetieg, Leibowitz and Kogelman, 1990), asset
allocation (Bostok, Woolley and Duffy, 1989), pricing of assets (Warner, 1977) and hedging (Bierwag, Kaufman
and Toevs, 1983).

In fact, a considerable attention has been made on the use of duration as an immunization strategy to eliminate
interest rate risk by matching the duration of two sides of positions. This may be done by one approach,
manipulated the duration of the portfolio, so that duration equals the time remaining in a planning period of the
portfolio (Kaufman, 1980). Or immunize by balance sheet approach. When the duration of assets equals that of
liabilities, both will change equally without changing the value of the equity (Kolb and Chiang, 1982).

However, since the elimination of interest rate risk is attainable, only, under highly restrictive assumptions
regarding acceptable pattern of the yield curve or interest rate movements. Each kind of acceptable rate shift
requires its own measurement of duration. Many attempts have been made to establish an alternative measure of
duration with its own immunization process that allows consideration of multiple shifts, which can change the
shape and location of the yield curve. See, for instance, Cox, Ingersoll and Ross (1979). However, the main
limitation of these attempts is that they apply to positive price assets only.

In fact, there has been a numerous number of literatures explaining, analyzing, examining and improving the
duration concept. Therefore, it is not possible to review, or even to mention all of these literatures in this essay.
However, it worthwhile mentioning, here, that the most important studies of duration are done by, Fisher and
Weil (1971). They provide a new measure of duration which allows for future rates to change, as we shall see
later on. Cox, Ingersoll and Ross (1979) provide another duration measure, which allows for more complicated
changes in interest rates.

In addition, Simonson and Hempel (1982) embedded duration concept in gap management approach, which can
be used to improve banks' performance, by managing the interest rate risks of bank's assets and liabilities. At
last, but not least, Bierwag, Kaufman and Khang (1978) provided an overview of duration and bond portfolio
analysis.

While most recent studies of duration emphases on the default-risk-free bonds, few studies examine the duration
of corporate bonds. Their conclusions, however, seem to be conflicting. Chance (1990) found that corporate
bonds have durations lower than their maturities and, thus, are less sensitive to interest rates than default-risk-
free bonds. Whereas Jacoby (2003) argues that the duration of a non-callable corporate bond is longer than its
Macaulay counterpart.

Kraft and Munk (2007) note that the duration of the defaultable coupon bond is smaller than that of the
equivalent default-risk-free bond, unless the default intensity is positively correlated with the default-risk-free
short-term interest rate. Other empirical literature provides information on this sensitivity. See, for example,
Longstaff and Schwartz (1995) and Bakshi et al. (2006).

Xie et al. (2009) examine the effects of default and call risk on bond duration. They find that call risk decreases
durations of default-risk-free bonds, while default-risk-free alone decreases durations for risky bonds, but with a
few exceptions. Using an option-based valuation model for coupon-bearing, callable and defaultable bonds,
Acharya and Carpenter (2002) examine the effects of default and call risk on bond duration. They show that call
or default risk alone reduces bond duration, but with bonds having both options, the results are different. Call
risk may increase the duration of defaultable bonds and default risk may increase callable bond duration. That is
so, because the exercise of one option rules out the exercise of the other. Different results are empirically
produced by Jacoby and Roberts (2003), who find that call risk always shortens duration, while default risk may
either lengthen or shorten it.

For zero-coupon bonds, Kraft and Munk (2007), once again, show that the duration of a corporate bond is
identical to that of a default-risk-free bond if default and recovery risk is independent of default-risk-free interest
rates.

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3. DURATION PROPERTIES

Duration is a technique used to measure the length of the stream of payment associated with a bond investment.
It is the weighted average of the stream of payments, where the maturity of each payment is weighted by the
proportion of the total value of the bond accounted for by the payment (Haugen, 1990). In other words, it is the
weighted average of the cash flow streams, where the weights are defined in terms of present value (Langetieg,
Leibowitz and Kogelman, 1990), i.e. the relative discounted cash flow in each period. Thus, for a zero coupon
bonds, duration is equal to the bond maturity.

4. MACAULAY'S DURATION

Duration is a technique used to measure the length of the stream of payment associated with a bond investment.
It is the weighted average of the stream of payments, where the maturity of each payment is weighted by the
proportion of the total value of the bond accounted for by the payment (Haugen, 1990). In other words, it is the
weighted average of the cash flow streams, where the weights are defined in terms of present value (Langetieg,
Leibowitz and Kogelman, 1990), i.e. the relative discounted cash flow in each period. Thus, for a zero coupon
bonds, duration is equal to the bond maturity.

When Macaulay (1938), in his pioneering work, searched for a correct measure of the life of a bond, he
recognized that the analysis of the interest rate risk of securities has to take into consideration more than just
their maturities (Gallant, 1988). As this tool measures only the time when the final cash flow takes place, which
ignores the fact that cash flows on a coupon bond, or any other fixed income security, are periodically paid over
the life of the bond in the form of coupons and, ultimately, a principal repayment. Macaulay's duration measures
the weighted average time of all cash flows, including coupon payments, using the present values of the cash
flows to determine the weighting. Thus, on the coupon date, duration (D) is computed as follows:

1  C1 C2 Cm 
D= × 1 × + 2 × + ... + m × ......................(1)
P  (1 + r )1 (1 + r ) 2 (1 + r ) m 

m
t × Ct
∑ (1 + r )
t =1
t
D= m
........................(2)
Ct
∑
t =1 (1 + r )
t

Where (t) is the time until receipt of each cash flow, (Ct) is the annual coupon payment as a percentage of
principal (face) value, (r) is the periodic discount rate, (m) is the number of cash flow dates, and (P) is the
current market value of the bond. Note that (Cm) includes coupon payment plus the principal payment.

To illustrate, duration can be considered as weights on a scale, as shown in figure (1), per which each cash flow
is a weight, with the largest weight the reimbursement of the principal of the bond. Each weight represents a
coupon payment (C) at time (t). Although C1=C2=…=Cm, time value of C1 is more than that of C2, and time
value of C2 is more than that of C3 and so forth. This fact is represented in figure (1) by the boldness of the
color. Boldest weight means more weight than the lightest one.

Accordingly, duration can be seen as a time weighted average, where cash date is weighted by the present value
of the cash flow paid by the bond on that date (Solnik, 1991). This means that duration measures the time
structure of a bond. It is the average time to a bond discounted cash flows (Brealy and Myers, 1991).

Indeed, duration is always less than or equal to maturity. This is the first property of duration as a measure of
time structure of a bond. This property is true because of some weight is given to cash flows in early years of the
bond's life and this helps to bring forward the average time at which cash flows are received. Also, duration
varies with coupon, yield and maturity. For a zero coupon bond, duration equals to maturity. For a perpetual
bond, duration is given by:

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 International Journal of Economic Perspectives, 2012, Volume 6, Issue 4, 46-56.

1
D= ..........................................................................................(3)
r∗
Figure (1) Illustration of Duration: Weights on a Scale

Where (r*) is the current yield, which equals to the yield to maturity (r) in the case of perpetual bonds. So, for
bonds having market prices above par (so, r ≤ r*), duration increases with maturity. For bonds trading at a
discount to par (so, r > r*), duration increases to a maximum at round 20 years, as Blake (1990) proposed, and
then declines towards the limit given by equation (3) above. Thus, in general, we can conclude that the second
property of duration is that, duration increases with maturity, as illustrated in figure (2).

Figure (2) Duration-Maturity Relationship

Bond Price Above Par Bond Price Below Par Perpetual

14

12

10

8
Duration

0
0 5 10 15 20 25 30
Term To Maturity

As the coupon falls, more of the relative weight of the cash flows is transferred to the maturity date and this
causes duration to rise. Furthermore, as yield decrease, the present values (weights) of all future cash flows fall
relatively more than those of the more distant cash flows. This increase the relative weight given to the more
distant cash flows and, thus, increasing duration. Therefore, the third property of duration is that it increases as
coupon and yield decreases (Blake, 1990), as illustrated in figure (3).

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Figure (3) Duration-Coupon-Yield Relationships

11% Coupon 9% Coupon 7% Coupon

0
Duration

0
0 1 2 3 4 5 6 7 8 9 10

Yield %

5. MODIFIED DURATION

Hicks (1939) and (1946) and Samuelson (1945) calculated the duration of a plain vanilla bond by starting with
bond pricing equation, then differentiate price with respect to yield and construct price elasticity. Thus, duration
measures not only the average maturity of a coupon bond, but also it measures bond price sensitivity to interest
rate movements. This gives modified duration. In fact, a bond's (or any other type of fixed income security)
volatility is related to its duration. The percentage change in price (dp) caused by a small change in interest rate
(dr) is given by:

1 dp 1 m Ct 1
× = − × ∑ (t × t +1
) = −D × = − D ∗ .............................(4)
P dr P t =1 (1 + r ) (1 + r )

So that:
D
D ∗ (in _ years ) = ..........................(5)
(1 + r )

Equation (4) is often called modified duration or interest rate sensitivity or volatility. It is a useful summery
measure of the likely effect of a change in interest rates on a debt portfolio (Brealy and Myers, 1991). However,
a coupon bearing bond with duration of (m) years has the same sensitivity to changes in interest rates as a zero
coupon bond with (m) years remaining (Solnik, 1991).

6. DURATION AND PRICE ELASTICITY

∗
Modified duration is used to find the price volatility as follow: Percentage Change in P = - D × Change in
Interest Rate.

dp dr
× 100 ≈ − D ∗ × ...........................(6)
P (1 + r )

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Where (r) is the yield to maturity used to calculate the price (P) of the security, (dr) is a change in the yield to
maturity, and (dp) is the corresponding change in the price. In the above equation, (6), the left hand side is
approximately equals the right hand side. It represents an accurate measure of the percentage price change
corresponding to a given change in the yield.

Holding the cash flows of the income stream fixed, the relationship between dp/p and dr/(1+r) is a true
relationship, shown as a curve in figure (4). Whereas equation (6) approximates this true relationship, with a line,
tangent to the curve at the origin, and the negative of the slope is duration (Bierwag, 1987).

Figure (4) Approximating Percentage Changes of Bond Price with Duration.

Notes: The x-axis represents (dr/1+r), while the y-axis represents (dp/p). The slope represents (–D), while the
dotted curve represents the true relationship.

From the above figure, (4), we can see that when (dr) is positive, the estimated percentage decrease in the price
exceeds the true percentage decrease. When (dr) is negative, the estimated percentage increase in the price is less
than the true percentage increase. If the (dr) is very small, then, the error in estimating the true percentage (dp/p)
is, also, very small.

We come, now, to the point where we should conclude the fourth property of duration. That is duration measures
the interest rate elasticity of the bond price, and is, thus, a measure of interest rate risk. The lower the duration,
the less responsive is the bond's value to interest rate fluctuations. Thus, bonds with long durations will be more
price volatile than bonds with shorter duration (Gallant, 1988).

7. FISHER WEIL DURATION

Since the sensitivity of a bond prices varies with the level of interest rates themselves, with large changes of
interest rates, duration does not stay constant. Fisher and Weil (1971) developed a new formula for duration that
allows for future rates to change, which is given by:

1 C1 C2 Cm 
Dfw = 1 × + 2× + ... + m × ...(7)
P  (1 + r1) (1 + r1)(1 + r 2) (1 + r1)(1 + r 2)...(1 + rm) 

The main issue in equation (7) is to estimate the future interest rates (r1, r2,..., rm). However, this may be
obtained by using the term structure procedures. That is might be done by giving the future market price of a
bond, and solve the above equation, for two coupon payments, to find C1. Next, apply the estimated value of C1
in the equation, for two coupon payments, and solve the equation for r2 and so on.

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Recently, Fabozzi (1996) provides a third method of calculating duration by perturbing, up and down, the yield
in the bond pricing equation and calculate the average effect of perturbation. This method is called the effective
duration. However, Babbel et al. (1997) suggest a model with a default-risk-free short-term rate and the value of
the issuing firm to estimate the relationship between corporate bond prices and default-risk-free interest rates.
They find that default-risk-free shortens the duration.

8. IMMUNIZING WITH DURATION

Since we have estimated the bond's price volatility and its interest rate risk, it is worthwhile to state, here, how to
immunize a bond portfolio against interest rate changes. The purpose of immunizing a portfolio, i.e. to have a
zero interest rate risk portfolio, is to guarantee a certain return over a horizon period. One way to do this is by
using some measure of duration.

To illustrate, consider the following cases:

(1) Immunizing in Case of a Single Payment Liability:

Suppose an investor has a liability with a single payment of 10,000 in 10 years. The current interest rate is %10,
and the term structure is flat. The present value of his/her liability is
10000
PV = = 3855.43
(1 + 0.10)10
Thus, he/she must invest now $3855.43 in order to accumulate enough cash to pay off his liability in 10 years.
That is so if, and only if, the interest rate on his/her investment remains at %10. Since the interest rates, however,
will not remain at %10, he/she has to immunize such interest rate risk. The liability has duration (D) equal to its
maturity, i.e. 10 years. That is so because it is a single payment.

To immunize, he/she should invest in a bond, or any fixed income security, that has the same duration as the
liability, that is 10 years. She/he has to find a bond that has a $3854.93 present market value and duration of 10
years. Such as a 20-year bond, with $5000 face value, carrying a $365.5 annual interest payment, computed as
follows:

365.5 365.5 365.5 + 5000

PV = 1
+ 2
+ ... + = 3854.93
(1 + 0.10) (1 + 0.10) (1 + 0.10) 20

and duration is calculated as follows:

1  365.5 365.5 365.5 + 5000 

D= × 1 × 1
+ 2× 2
+ ... + 20 ×  = 9.9165 years
3855  (1 + 0.10) (1 + 0.10) (1 + 0.10) 20 

By immunizing in this way, the investor will guarantee a $10,000 cash flow in 10 years, which equals to his/her
liability.

(2) Immunizing in Case of a Multi Payment Liability

Suppose our friend, the above mentioned investor, managing a pension fund, and face a stream of required
payments as show in figure (5).

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Figure (5) Cash Flows Associated with Liability.

1200000.0000

1000000.0000

800000.0000

600000.0000
$$$

400000.0000

200000.0000

0.0000
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Time (Year)

The duration of this stream of cash flows, depends on the interest rate used to compute its present value. The
higher the yield the lower the duration. This is so, as we have seen before, because with higher yields the more
distant payments accounts for smaller proportion of the total present value. Thus, for instance, at an interest rate
of %10, the duration might be 7 years and at %4 the duration might be as high as 10 years. Hence, each stream
of liability has its own immunization. Figure (6) shows the immunization curve, per which immunizing a
portfolio should take place on that curve. So, if our friend invests in a bond with a yield of %10 and duration of 7
years, then his/her investment is immunized, if he/she takes a position on the immunization curve. As well as, if
he/she invests in a bond yields %4 and has duration of 10 years.

Figure (6) Immunizing with Multi-Payments Liability

120000%

100000%

80000%
Internal Yield%

Immunization Curve

60000%

40000%

20000%

0%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Years

In conclusion, to immunize investor should construct a portfolio of bonds such that its duration is equal to the
duration of his/her liabilities. She/he must re-immunize with each change in interest rates. That is so because as
interest rates change, duration changes, as well.

9. LIMITATIONS OF A DURATION BASED TECHNIQUE TO ESTIMATE BOND RISK

As we have seen in the previous section, duration has been used to indicate the volatility of bond prices to
changes in interest rates. The bond holder can, thus, determine the sensitivity of the price of bond to changes in
interest rates, once he has calculated the duration of the bond. In fact, duration is one of the most popular
measures of the risk of bonds investment. Considering the bond as a portfolio of individual payments, its
maturity is a weighted average of maturities of the payments in the portfolio. As duration measures the response

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of the price of a bond to changes in interest rates. It measures such response of the value of a portfolio to changes
in interest rates, as well.

Haugen (1990), however, argues that, there are, at least four limitations to duration as a measure of the risk of a
bond portfolio:
Firstly, although duration undertakes the risk associated with changes in interest rates, it does not focus on
changes in the market value of bond portfolio that result from changes in the bond's projected income stream.
These changes may result, for instance, from changes in the market's evaluation of the probability of default.

Secondly, all measures of duration are limited in terms of the type of changes in yield to maturity they relate to.

Thirdly, duration, as a measure of price volatility of a bond, indicates that long duration bonds are more price
sensitive to changes in yield to maturity than are short duration bonds. However, Haugen (1990) argues that, it is
also true that short duration yields to maturity are more volatile than are long duration yields. And, thus, both
factors should be taken into consideration in assessing risk of a bond.

Finally, it is rather difficult to measure the duration of other securities, such as common stocks. In case of a
mixed portfolio, consists of bonds and stock, duration does not provide an appropriate or adequate measure in
assessing the risk of that portfolio.

However, it might be proposed that, for such a mixed portfolio, one way to measure its risk is by splitting it into
two parts: The bonds part, which one can easily measure its interest rate risk. And, the stock part, which one can
apply the traditional techniques of risk management.

10. CONCLUSION

The duration of a bond with promised cash flows at specific dates is a function of the time pattern of these cash
flows and of the yield to maturity. It is a measure of the average time of a bond, or any other fixed income
security. It is the weighted average maturity of the cash flow stream, where the weights, are the present values of
the cash flows that occur at each point in time (Langetieg, Leibowitz and Kogelman, 1990). In this sense,
duration measures the time structure of a bond. The properties of this relationship can be summarized as follows:

(1) The duration of a bond is always equal or less than its maturity.
(2) For a zero coupon bond, duration equals its maturity. Its duration declines in a straight line between the
present time and that maturity date.
(3) All else being equal, the duration of a bond increases as the maturity increase, and, then, decreases in
nonlinear steps to zero at the final maturity date.
(4) All else being equal, duration of the bonds tend closer and closer to the perpetuity duration as maturity
increases.

Duration, also, is a measure of the elasticity of the market price of an asset (liability), the present value of
projected stream of cash payments, outflows, with respect to the market discount rate (Bierwag and Kaufman,
1988).

So that, duration can be seen as proportionality constant that links change in the present value of a stream of
future cash flows to changes in market interest rates by yield curve segment (Simonson and Hempel, 1982).

Therefore, duration has been used to indicate the sensitivity of bond prices to changes in interest rates (Bostock,
Woolley and Duffy, 1989). In this sense, duration measures bond's interest rate risk. The properties of this
relationship can be summarized as follows:
(1) All else being equal, these are the maturity and the yield to maturity. The duration of a bond decreases
as the coupon rates rises.
(2) All else being equal, duration of a bond decreases as the yield to maturity rises.
(3) Duration represents an accurate measure of interest rate elasticity of the bond price. However, a coupon
bearing bond with duration of (M) years has the same sensitivity to changes in interest rates as a zero
coupon bond with (M) year remaining.
There are, however, many limitations to duration as a measure of the risk of a bond portfolio.

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