Duration
Duration
Welcome to our trading glossary entry, where we demystify the complex jargon of the financial world. Today, we are exploring a technical term called Duration. This term has a pivotal influence on both bond and equity trading.
Simple Definition of Duration
In the simplest terms, Duration is a measure of the sensitivity of a security's price to changes in interest rates. In other words, it estimates how much the price of a security, like a bond, will change when interest rates move.
Terms You Need to Know
Before we dive deeper into our exploration of Duration, there are a couple of related terms you'll need to understand:
Interest Rate: This is the proportion of a loan charged as interest to the borrower, usually expressed as an annual percentage of the loan.
Price Sensitivity: This refers to how a change in a single factor might influence the price of a specific security or share.
Security: A security is a tradable financial asset which can range from bank or government debt to shares in a company.
How Duration Works in Trading
Duration is a complex measure that takes into account both the payment of coupons (periodic interest payments) and the repayment of the original investment. Because of its complexity, professionals often use it to assess risks associated with different securities. Duration helps us to understand the degree of risk and potential volatility of a security in relation to changes in interest rates.
Types of Duration
Understanding Duration becomes easier when you know it has various forms:
Macaulay Duration: This type of duration is an estimate of a bond's price sensitivity to changes in interest rates.
Modified Duration: This form of duration takes into account the expected change in a bond's price given a 1% change in interest rates.
Effective Duration: This version of duration measures the price sensitivity of a bond with an embedded option, considering changes in the bond's cash flow due to changes in interest rates.
Wrapping Up
So there you have it. You now know that the term Duration refers to the level of sensitivity a security's price has to changes in interest rates. Understanding and calculating duration can be incredibly useful tools in your trading strategy, especially when trading bonds. Remember, the longer the Duration, the greater the interest rate risk. In essence, Duration is a tool to gauge risk and is essential to grasp for any trader.
We hope this glossary entry was informative and would help you navigate the trading environment more confidently. For more such terminologies and ideas, stay tuned!
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