What does the term 'duration of bonds' indicate?

What does the term 'duration of bonds' indicate?

• A. Average maturity of a bond portfolio
• B. Sensitivity of a bond's price to interest rate changes
• C. Risk of default in bond investments
• D. Stability of bond returns

Answer: (B)

The term 'duration of bonds' specifically indicates the sensitivity of a bond's price to changes in interest rates. Duration is a measure that reflects how much the price of a bond is expected to change when there is a change in interest rates, making it a crucial concept for understanding interest rate risk in the bond market. Duration takes into account both the time until a bond's cash flows are received (including interest payments and the return of principal) and the magnitude of these cash flows. A bond with a longer duration will generally have a greater price sensitivity to changes in interest rates compared to one with a shorter duration. This is because longer-duration bonds have cash flows that are further in the future, making them more affected by changes in the prevailing interest rates. Understanding duration helps investors manage the risks associated with fluctuations in interest rates, allowing them to make informed decisions when constructing their bond portfolios. In contrast, while average maturity, risk of default, and stability of returns are important financial concepts, they do not capture the essence of how bond prices react specifically to interest rate changes, which is the core meaning of 'duration'.

The term 'duration of bonds' specifically indicates the sensitivity of a bond's price to changes in interest rates. Duration is a measure that reflects how much the price of a bond is expected to change when there is a change in interest rates, making it a crucial concept for understanding interest rate risk in the bond market.

Duration takes into account both the time until a bond's cash flows are received (including interest payments and the return of principal) and the magnitude of these cash flows. A bond with a longer duration will generally have a greater price sensitivity to changes in interest rates compared to one with a shorter duration. This is because longer-duration bonds have cash flows that are further in the future, making them more affected by changes in the prevailing interest rates.

Understanding duration helps investors manage the risks associated with fluctuations in interest rates, allowing them to make informed decisions when constructing their bond portfolios. In contrast, while average maturity, risk of default, and stability of returns are important financial concepts, they do not capture the essence of how bond prices react specifically to interest rate changes, which is the core meaning of 'duration'.