Duration is a measure of a bond’s or fixed income portfolio’s sensitivity and adaptability to interest rate changes. As interest rates rise, the higher a bond’s duration, the more its price will fall. When interest rates drop, the price of maturing bonds will rise, even though investors are tendering them in and will receive back the same amount. This effect becomes more pronounced with longer durations.

Maturity and coupon rate are the two core factors that can influence a bond’s duration (or Macaulay duration). The longer the maturity, the longer the duration. Bonds of shorter maturities, with small coupon rates and low yields tend to have lower duration. Modifying a bond’s coupon rate will limit its duration, for instance, a 10-year bond with a high coupon rate may have a lower duration than a 10-year bond with a low coupon rate at the same yields because the cash flows from the higher coupon-paying bond can be reinvested at higher yields at earlier points in its life.

Macaulay duration is a measure of the average life of a bond and estimates how many years it will take an investor to be repaid the bond’s price by its total cash flows. The formula for calculating Macaulay duration involves summing the present value of each cash flow, dividing it by the current market price of the bond, and then discounting it back with the market yield.

Modified duration measures the price change in a bond given a 1% change in interest rates. It is the derivative of Macaulay duration and gives a more accurate picture of how prices of bonds may be impacted by changes in interest rates. To calculate modified duration, the Macaulay duration is divided by 1 plus the coupon rate. It measures how a bond’s price will react to a 1% change in the interest rate.

The duration of a fixed income portfolio is computed by weighing each of the individual securities held in the portfolio and taking the weighted average of the respective durations of these bonds. A portfolio’s duration is useful for analyzing how a portfolio will react to changes in interest rates. A small change in duration could significantly wipe out whatever advantage an investor may hope to gain from holding his bonds in a portfolio. It is therefore important to keep an eye on the duration of a portfolio and monitor it as changes occur in the interest rate environment.