One way to grow your money, diversify your investments and hedge against risk is to buy bonds. Bonds are investment products that pay a fixed rate of interest until they reach maturity, at which time they pay back your initial investment. While most bonds are low-risk investments, they still carry certain risks that metrics such as duration help investors understand and account for.
Duration can refer to several types of measurements that assess risk in a bond or portfolio of bonds. The value of a bond portfolio changes based on interest rates, which factor in duration calculations. For a single bond, duration measures how much that bond is exposed to interest rate risk, which refers to the possibility that an investor will be locked into owning a bond even when other investments that offer higher interest rates become available.
Investors can use financial formulas to determine duration for individual bonds as well as bond portfolios. Duration for a portfolio is essentially an average of the duration of bonds within the portfolio, accounting for what percentage of the total portfolio each bond represents. Bond immunization is the process of shaping a bond portfolio so that it has a specified duration based on an investor's needs and risk tolerance.
In some cases, investors choose to calculate the duration of a portfolio of bonds as a number of years. This process uses the Macaulay duration model, which is a formula that accounts for a bond's interest rate, payment rate and time until maturity. The result of a Macaulay duration calculation for an individual bond, or a full portfolio of bonds, is a number that represents how many years it will take for the investment to produce returns that cover its true cost.
You also can calculate a bond portfolio's duration as a percentage. In this case you'll need to use a formula other than the Macaulay duration model. However, most alternative duration measures, such as modified and effective duration, rely on the same basic calculations and data as Macaulay duration. When the duration of a portfolio is expressed as a percentage, it refers to the percentage change that a bond's price will experience for every 100 base points (or 1 percent) of interest rate change.
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