Can you explain Duration in layman terms?

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Duration is one of the favourite question of an interviewer.

Simple answer:

Sensitivity in your portfolio value with respect to changes in your interest rate is called as Duration.

For ex: If i say that Duration of my portfolio is 5, then it means if i decrease 1% interest rate then there will be 5% increase in my portfolio value.

Now you will think how can you say whether portfolio value will increase or decrease


Ans: Simple point is that your portfolio value is the discounted value of your future cashflows.

X = y/(1+i)

so if you decrease your interest rate in this equation then the value of X will increase. Isn't it?

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Application Use: An actuary will want to know how much volatile his portfolio is due to interest rate because he has to match those assets with the liabilities. Assets and Liabilities are both present value of future cashflows in an insurance company while doing actuarial valuation. So it can be possible that decrease in your interest rate may leads to more increase in your liabilities than your assets and then it will be a problem. 

Just because of this immunisation concept into book which says that 

 

1.     Present Value of assets = Present value of Liabilities

2.     Duration of Assets = Duration of Liabilities

There is one more condition though but we will discuss that in upcoming articles.

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