Hi I understand the concept of Macaulay duration, but I’ve come across a statement on Analystnotes that’s got me scratching my head.
Here’s the statement: The Macaulay duration statistic identifies investment horizon so that the losses/gains from coupon reinvestment offset the gains/losses from market price changes.
Can someone please explain the above sentence to me.
Thanks a ton.
If interest rates change, then the price on the bond changes, and the reinvestment rate changes.
The statement is saying that if you compare the future value of the bond plus coupon payments plus reinvestment interest if rates _ don’t change _ to the future value of the bond plus coupon payments plus reinvestment interest if rates _ do change _, the Macaulay duration is the amount of time until those values are equal.
For example, suppose that a bond has a Macaulay duration of 6 years, and that interest rates rise 1% and remain constant thereafter. The value of the bond will decrease (about 6%), but the reinvestment rate will increase 1%. Initially, the value of the bond plus coupons plus reinvestment income will be less than it would have been had rates remain unchanged, but after 6 years, the value of the bond plus coupons plus reinvestment income will be the same as they would have been had interest rates not changed. After 6 years, the value with the interest rate rise will be higher than it would have been with no interest rate rise. So, after the interest rate increase the value is less than it would have been, but eventually it becomes more than it would have been; the time when they cross is 6 years from today.