Question

Explain what makes bonds more sensitive to discount rate changes, and how Duration measures bond sensitivity. Why does higher Duration mean greater sensitivity, and lower Duration less (explain by using the equation, in terms of the present value of the coupon and principle payments)?

Answer 1

Bonds are sensitive to the discount rate changes when they are having a lower coupon rate and having a higher maturity period and the bonds will be having a lower coupon rate then they are having a substitute problem of getting replaced by different market interest rate and they will react with a higher sensitivity.

When the bonds are having a longer time period,t it will mean that the longer duration will be leading to higher sensitivity as it would be leading to change in the rate of return of the bond for the longer period of time.

Higher duration will mean higher sensitivity because coupon rate will be getting affected in the longer period of time and rate of return will be getting affected in the longer period of time whereas lower sensitivity in lower period of time because there is a lower time period for getting affected by changing the interest rates.