What is Duration?
Duration measures how sensitive a loan's price is to changes in interest rates. Modified Duration estimates the percentage price change for a 1% (100bp) change in yield. Macaulay Duration is the weighted average time to receive cashflows. For whole loans, effective duration (calculated using actual price changes from rate shocks) is preferred because it captures the non-linear relationship between rates and prepayment behavior. Longer duration means more interest rate risk; a 5-year duration loan loses approximately 5% of value for every 100bp rate increase.
Formula
Modified Duration = -1/P x dP/dy Effective Duration = (P(-) - P(+)) / (2 x P(0) x delta_y) Where P is price and y is yield
How LoanBook Uses Duration
LoanBook calculates effective duration using the OAS engine's scenario analysis, shocking rates up and down and repricing with dynamic prepayment response. Duration is displayed in portfolio analytics and used in ALM (asset-liability management) risk assessment.
Frequently Asked Questions
Why is effective duration better than modified duration for whole loans?
Modified duration assumes cashflows don't change when rates move. But whole loan prepayments are rate-sensitive; when rates drop, prepayments increase, shortening the loan's life. Effective duration captures this dynamic by repricing with updated prepayment assumptions at each rate level.
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