The Basic Macaulay Duration Theories and Limitations that are Necessary for Investors to Know

DOI

10.2991/aebmr.k.220307.190How to use a DOI?

Keywords

Macaulay duration; Interest rate risk; Modified duration; Callable bond; Effective duration

Abstract

The concept of duration was proposed by Frederick Macaulay in 1938 and has become a popular tool for measuring financial instruments nowadays. This paper not only provides investors with a detailed introduction to Macaulay Duration and affirms its role but also reminds investors of Macaulay duration’s limitations and offers solutions to address them. It starts from reviewing the derivation idea of Macaulay duration and explaining the rationality of its weighted average value at the time of receiving cash flow. Next, some Macaulay duration theories are detailed, including that the Macaulay duration of bonds is less than or equal to its maturity; the Macaulay duration of zero-coupon bonds is longer than that of coupon bonds with the same maturity date; and the longer the Macaulay duration, the stronger the sensitivity of bond price to interest rate changes. Based on these definitions and properties, the Macaulay duration is widely used to measure bonds’ time structure and risk. However, the Macaulay duration still has some limitations. It can neither calculate the specific sensitivity of bond price to interest rate changes nor be applied to financial instruments with non-fixed cash flow, such as callable bonds. Therefore, to make up for these two shortages of Macaulay duration, economists have introduced new duration models, namely modified duration and effective duration. Investors can use this paper as a reference to determine whether the information they need is not available from the Macaulay duration or whether the bonds they invest in apply to the Macaulay duration. If the answers are no, they can then choose to meet their requirements with either modified duration or effective duration.

Copyright

© 2022 The Authors. Published by Atlantis Press International B.V.

Open Access

This is an open access article under the CC BY-NC license.

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TY  - CONF
AU  - Zeyuan Zhang
PY  - 2022
DA  - 2022/03/26
TI  - The Basic Macaulay Duration Theories and Limitations that are Necessary for Investors to Know
BT  - Proceedings of the 2022 7th International Conference on Financial Innovation and Economic Development (ICFIED 2022)
PB  - Atlantis Press
SP  - 1146
EP  - 1151
SN  - 2352-5428
UR  - https://doi.org/10.2991/aebmr.k.220307.190
DO  - 10.2991/aebmr.k.220307.190
ID  - Zhang2022
ER  -