What is duration and why is it important?

• A. Duration measures a bond's price sensitivity to interest-rate changes; higher duration means greater price change.
• B. Duration measures credit risk of a bond.
• C. Duration is the same as maturity.
• D. Duration only matters for zero-coupon bonds.

Answer: (A)

Duration is the measure of how much a bond’s price is expected to move when interest rates change. It sums up the timing and size of all the bond’s cash flows into a single number in years, giving a picture of price sensitivity. In practical terms, for small changes in yield, the price change is roughly proportional to the negative of duration: a higher duration means a bigger price drop when yields rise and a bigger price rise when yields fall.

This is why the correct choice says duration captures price sensitivity to interest-rate changes and that higher duration leads to greater price change. It’s not a measure of credit risk, and it isn’t simply the same as maturity (except for zero-coupon bonds, where duration happens to equal maturity). Duration applies to all bonds, not just zero-coupon ones. For example, a bond with a duration of 6 years will lose about 6% in price if yields rise by 1 percentage point (all else equal), illustrating how duration quantifies that sensitivity.