**Interest rate risk** is the sensitivity of a bond’s value to variability of market interest rates/yields. In general, as interest rates increase, bond prices decrease (and vice versa). A bond’s **duration** is the number of years it takes for a bond to pay out its original cost by its internal cash flows and is the common measure of a bond’s interest rate risk. A bond’s duration is also interpreted as how the bond price is affected by interest rate changes. For example, we expect that the price of a bond with duration of 5 years to fall 5% if the market interest rate increases by 1%, and to rise 5% if the interest rate decreases by 1%. A higher duration indicates a higher interest rate risk of a bond. Note that the duration of a zero-coupon bond is always equal to its time to maturity.

*Duration = – percentage change in bond price / percentage change in yield*

The factors affecting duration are:

**Maturity.**If two bonds are identical except for maturity, the one with shorter maturity has the lower duration as the bond which matures sooner would repay its original cost more quickly.**Coupon rate.**If two bonds are identical except for coupon rate, the bond with lower coupon has higher duration as it will pay back its original cost slower than the higher coupon bond.**Call feature.**If two bonds are identical except for the embedded call option feature, the bond with call option has lower duration than the option-free bond. It limits the upward movement of the bond price when interest rate decreases as the bond price will not rise above the call price.**Put feature.**If two bonds are identical expect for the embedded put option feature, the bond with put option has lower duration than the option-free bond. It limits the downward movement of the bond price when interest rate increases as the bond price will not fall below the put price.