Aurora Borealis
1 September 1989 Financial Analysts Journal Volume 45, Issue 5

A Total Differential Approach to Equity Duration

  1. Martin L. Leibowitz, PhD
  2. Eric H. Sorensen
  3. Robert D. Arnott
  4. H. Nicholas Hanson

Most of the risk associated with fixed income price movements is accounted for by their duration—that is, their sensitivity to changes in the discount rate. Thus, for bonds, duration and interest rate sensitivity are virtually synonymous. For equities, however, duration is only one of several factors describing risk.

A major source of confusion in evaluating equity duration is the definition of “duration” itself. Measured as a function of the sensitivity of stock price to the discount rate—ignoring all links between the discount rate and the growth rate—the traditional dividend discount model (DDM) duration is long—20 years or more. But this measure of duration fails to take into account the offsetting effects of inflation-induced rate increases on corporate profits.

A measure of the total sensitivity of stock prices to interest rate movements recognizes that the two components of nominal interest rates—inflation and the real rate—affect both the equity discount rate and the equity earnings growth rate, but not necessarily in the same direction. The stock market as a whole is less sensitive to changes in inflation expectations than to changes in real rates, because most companies can raise prices, hence nominal growth rates, in times of inflation. Thus a measure of stock price total sensitivity to interest rates will generally be substantially shorter than the duration measure derived from the traditional DDM.

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