Portfolio Risks - Duration and Stock Risks
The primary measure of bond price volatility is duration. It takes into account both the length of time to maturity and the difference between the coupon rate and the yield to maturity. Here are some of the most important facts about duration:
- The longer the duration of a particular bond, the more its price will fluctuate in response to interest rate changes.
- Duration is always equal to or less than the years to maturity of the bond.
- Duration can help to calculate the impact of interest rate changes on the price of the bond. For example, a bond with a duration of 8 is likely to decrease 8% for every 100 basis points increase in market interest rates.
- Duration is a weighted average term to maturity.
- As payment frequency increases, duration decreases.
Exam Tips and Tricks
A zero-coupon bond, with only one payment (at the end of the term), has the highest duration of any bond and is therefore the most sensitive to price changes due to interest rate changes.
Here are some risks associated with investing in the stock markets:
- Systematic risk - Also known as market risk, this is the potential for the entire market to decline. Systematic risk cannot be diversified away.
- Unsystematic risk - This is the risk that any one stock may go down in value, independent of the stock market as a whole. This risk may be minimized through diversification. This also incorporates business risk and event risk (as described in the "Bond Risks" section).
- Business risk- The risk that a company will not make enough money to stay in business.
- Regulatory risk - The risk that laws may change and impact the business, industry or governmental entity, thus having an impact on the value of the security
- Other risks - Opportunity risk and liquidity risk (both described in the "Bond Risks" section) may also apply to stocks in a portfolio.