Introduction: What is Macaulay Duration?
When it comes to investing in bonds, one of the most important concepts to understand is duration. Duration measures the sensitivity of a bond’s price to changes in interest rates. Macaulay duration, named after Canadian economist Frederick Macaulay, is a commonly used measure of bond duration. In this article, we will break down the formula for Macaulay duration in relaxed English, so you can better understand this key concept in fixed income investing.
The Macaulay Duration Formula
Macaulay duration is calculated using the following formula:
Macaulay duration = (C1 x T1 + C2 x T2 + … + Cn x Tn) / P
- C1, C2, …, Cn = the cash flows of the bond at different times
- T1, T2, …, Tn = the time until each cash flow is received
- P = the price of the bond
Let’s say you have a bond that pays a coupon of $50 every year for five years, and then returns the principal of $1,000 at the end of the fifth year. The bond is currently priced at $950. Using the Macaulay duration formula:
Macaulay duration = [(50 x 1) + (50 x 2) + (50 x 3) + (50 x 4) + (1,050 x 5)] / 950 = 4.37 years
This means that if interest rates were to increase by 1%, the price of the bond would be expected to fall by approximately 4.37%.
Interpretation of Macaulay Duration
Macaulay duration represents the weighted average time until a bond’s cash flows are received, with the weights being the proportion of the bond’s total present value that each cash flow represents. In other words, it tells you how long it will take for the bond’s cash flows to pay you back the price you paid for the bond. The higher the Macaulay duration, the more sensitive the bond is to changes in interest rates.
Let’s say you have two bonds, Bond A and Bond B. Bond A has a Macaulay duration of 5 years, while Bond B has a Macaulay duration of 10 years. If interest rates were to increase by 1%, Bond B would be expected to experience a larger price decline than Bond A, because its longer duration makes it more sensitive to changes in interest rates.
Limitations of Macaulay Duration
While Macaulay duration is a useful measure of bond duration, it does have some limitations. For one, it assumes that interest rates will change by the same amount for all maturities. In reality, changes in interest rates can be uneven across the yield curve, which can affect the accuracy of Macaulay duration as a predictor of bond price changes. Another limitation is that Macaulay duration does not take into account the reinvestment of cash flows. If interest rates were to increase, the bond’s cash flows could be reinvested at a higher rate, which could offset some of the price decline caused by the higher interest rates. This is known as the “reinvestment risk” of a bond.
Understanding Macaulay duration is essential for fixed income investors who want to manage their interest rate risk. By knowing the formula for Macaulay duration, investors can better interpret the sensitivity of their bonds to changes in interest rates. While Macaulay duration has its limitations, it remains a key tool for bond investors seeking to optimize their portfolios.