Duration

Duration measures a bond's:

1. A.Time to the first couponDuration is quoted in years, which is why time-based answers feel right. It is a weighted average of the timing of all the bond's cash flows, used to gauge price sensitivity, not a countdown to the next interest payment.
2. B.Price sensitivity to interest-rate changesCorrect - higher duration means more rate sensitivity.
3. C.Default probabilityDefault probability comes out of credit analysis and shows up in ratings and spreads. Duration is built from the timing of cash flows and the yield, which is why a Treasury carrying no default risk can still have a long duration.
4. D.LiquidityLiquidity describes how easily a bond can be sold near its quoted price and shows up in trading volume and spreads. Duration says nothing about marketability; it measures how much the price moves when yields change.

Why: Duration gauges a bond's price sensitivity to changes in interest rates.

A bond with a duration of 4 will, if interest rates fall 1%, rise in price by about:

1. A.0.4%This is off by a factor of ten, as though rates had moved a tenth of a percent rather than a full point. Multiplying a duration of 4 by a 1% change gives 4%.
2. B.14%A 14% price move on a 1% rate change would imply a duration of 14, characteristic of a very long-dated bond. This bond's duration is 4, so its expected move is correspondingly smaller.
3. C.4%Correct - duration x rate move.
4. D.1%1% is what a bond with a duration of about 1, such as a very short-dated note, would do. Duration is the factor that translates the yield change into a price change, and at 4 it makes this bond four times as sensitive.

Why: Price change is approximately duration x rate change = 4 x 1% = 4%.

A bond with a duration of 6 would, if interest rates rise 1%, fall in price by roughly:

1. A.6%Correct - duration x rate move.
2. B.16%This adds the duration and the rate change in the wrong way and overstates the move by more than double. The relationship is multiplicative: duration times the rate change gives roughly 6%.
3. C.0.6%This divides by duration instead of multiplying, misplacing the decimal by a factor of ten. Duration measures how many percent the price moves per one percent change in yield, so a duration of 6 amplifies the move rather than shrinking it.
4. D.1%This simply repeats the rate change and ignores duration entirely. If price always moved one-for-one with yields, duration would carry no information and long bonds would be no riskier than short ones.

Why: Price change is approximately -duration x rate change = -6 x 1% = -6%.

A client near retirement worried about rising interest rates should generally prefer:

1. A.Shorter-duration bondsCorrect - less rate sensitivity.
2. B.Only equitiesMoving entirely to equities does sidestep bond price risk, but it trades a modest problem for a much larger one. A client near retirement needs the stability fixed income provides, and shortening duration keeps that stability while cutting rate sensitivity.
3. C.Zero-coupon 30-year bondsA 30-year zero has the longest duration of any bond, since all its cash flow arrives at maturity with no coupons to shorten it. That makes it the most rate-sensitive instrument available, the exact opposite of what this client needs.
4. D.The longest-maturity bonds availableLonger maturity means longer duration and larger price declines when yields rise. Reaching for the higher yield on long bonds increases exactly the exposure the client is trying to avoid.

Why: Shorter-duration bonds are less sensitive to rate increases, reducing price risk.