Advanced Diploma of Financial Planning (ADFP) Practice Test

What does duration provide investors with in terms of bonds?

1. A way to measure credit risk

2. A method to compare a bond's volatility to that of other bonds

3. A way to forecast interest rate changes

4. A measure of the bond's yield

The correct answer is: A method to compare a bond's volatility to that of other bonds

Duration is a key concept in bond investing that measures the sensitivity of a bond's price to changes in interest rates. It serves as a tool for investors to assess how much the price of a bond is likely to fluctuate when interest rates change, thereby providing a method to compare the volatility of different bonds. When interest rates rise, bond prices generally fall, and vice versa. Duration quantifies this relationship by indicating how much the price of a bond will change for a given change in interest rates. A bond with a longer duration is typically more sensitive to interest rate changes compared to a bond with a shorter duration. This allows investors to evaluate and compare the relative interest rate risk associated with different bonds. Understanding duration helps investors make more informed decisions based on their risk tolerance and expectations regarding future interest rate movements. Therefore, using duration as a method to compare bonds' volatility directly addresses the core idea of managing interest rate risk in bond portfolios. The other options listed, such as measuring credit risk, forecasting interest rate changes, or assessing a bond's yield, do not align with the primary purpose of duration. They represent different aspects of bond analysis or risk assessment, but they are not focused on the fundamental relationship that duration captures between interest rate movements and bond price