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Duration - how it is used

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Published: 13th February 2010 by William Webster

Duration measures interest rate risk. Duration can therefore be used to control this risk. In the following "duration" refers to modified duration.

How would a fund manager use duration? He (or his investment committee) would target the duration for the investment portfolio.

The duration of the portfolio would need to suit the investment horizon. If 10 years is considered too risky and 1 year does not appropriately reflect the risk appetite the duration target could be set between 3 years and 5 years. What is the effect of this target?

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Duration is used to measure interest rate risk. It is the weighted average life of bond's present values and is expressed in years. As an approximation, a financial instrument that has a duration of 1 year will lose 1% of its value for a 1% increase in interest rates. A financial instrument with a duration of 3 years will lose 3% of its value for a 1% increase in interest rates. The greater the portfolio duration the greater the interest rate risk you run.

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