What is the effect of duration on a fixed income investment's price?

Duration is a key measure that reflects the sensitivity of a fixed income investment's price to changes in interest rates. When duration increases, it indicates that the investment is more sensitive to interest rate fluctuations; thus, its price will experience more significant changes in response to interest rate movements.

For example, if interest rates rise, the price of a bond with a longer duration will decrease more than the price of a bond with a shorter duration. This relationship occurs because longer-duration investments take more time to pay back their cash flows, making them more vulnerable to interest rate changes. Conversely, shorter-duration investments usually experience smaller price changes because their cash flows are received sooner.

Understanding duration is crucial for investors who are managing the interest rate risk associated with fixed income securities, as it directly relates to how much the price of these securities will fluctuate when market interest rates change.