The term ‘duration’ has many different definitions, depending on the context in which it is used. In general, duration can be thought of as the length of time something lasts. For example, the duration of a movie can be two hours, the duration of a song can be three minutes, and the duration of a pregnancy can be nine months.
In finance, duration is a measure of the sensitivity of the price of a security to changes in interest rates. For example, if a bond’s price decreases by 1% when interest rates increase by 1%, then the bond has a duration of 1%. Duration is often expressed in years.
There are two types of duration: modified duration and effective duration. Modified duration is a measure of price sensitivity that takes into account the possibility of reinvestment at the new interest rate. Effective duration is a measure of price sensitivity that takes into account the timing and amount of cash flows from the security.
Both modified and effective duration are affected by factors such as coupons, maturity date, call provisions, and yield curve shape.