ABSTRACT

In this chapter, the authors introduce and examine the concept of duration, a concept familiar in the finance literature but all but unknown to economists, including the small group of economists working in the area of capital theory. In well arbitraged markets the term structure of interest rates (the yield curve) reflects the pattern of expectations of traders regarding future short-term rates. Thus, for coupon bonds, the yield-to-maturity will equal the simple average of the (expected) one-period discount rates, or the holding-period yield, only if all the rates are equal (that is, only when the yield curve is flat). The pattern of interest rates in financial markets at any point in time is, in large part, a distillation of the subjective preferences and expectations of the many trading individuals in the market. In addition, duration as a measure of the average waiting period, simultaneously measures the sensitivity of the (capital) value of the investment to changes in the discount rate.