Hi Guys, I am new to this forum so hope that I have posted in the correct place. I am struggling to get my head around the fundamentals of Macauley Duration. Firstly the answer comes in years, as the time until each promised payment is to be made. However I thought each payment was annual/semi-annual (depending on information in question) and therefore the payments time is known already?
Any help on this please
Cheers,
I wrote an article on duration that may be of some help here: http://financialexamhelp123.com/macaulay-duration-modified-duration-and-effective-duration/
Hi S2000 Magician, I read your article however I still confused as to why the weighted averaged average doesn’t equal the overall time it takes to receive the bond amounts. Surely the weightings should equal the number of years. Ie in your example the answer should be 5 rather than 4.49.
^You’re confusing a bond’s DURATION with its TERM. These two are not the same thing.
Think of duration as a weighted average of the cash flows. If you think of it this way, the duration HAS to be lower than the term, because you’re getting some cash back at the end of year 1, some at the end of year 2…and so on, until you get the final bond payment and the return of the principal.
Note - when I went through the CFA program, it did not test McCaulay duration. It only tested Effective Duration. The concept is similar, but make sure you’re not trying to understand something that isn’t tested.
Greenman: LOS 56-b says “define, calculate, and interpret Macaulay , modified, and effective durations”
I doubt they’d actually make a candidate do the actualy calculation of a Macauley duration (due to the amount of time it takes to do it). However, a description of the calculation and the relationships betwen the different durations would clearly be fair game. It’d also be a good idea to make sure they know how the bond’s Macauley duration is related to investment horizon and price vs. reinvestment rate risk. For investment horizons less than the MD, price risk dominates, but for ones longer than the MD, reinvestment risk dominates.
If I give you $1 tomorrow and $1 the next day, is that the same as giving you $2 in 2 days?
Of course not; in the first scenario you get half your money in one day and half in 2 days, whereas in the second you get all of it in 2 days. The average time to get your money in the first scenario is (about) 1½ days; the average time to get your money in the second scenario is exactly 2 days.
That’s what Macaulay duration is doing: computing the (weighted) average time until you get your money.