In 1938, Frederick Macaulay published his classic book, Some Theoretical Problems Suggested by the Movements of Interest Rates, Bond Yields and Stock Prices in the United States Since 1865.1 Although Macaulay focused primarily on the theory of interest rates, as an aside he introduced the concept of duration as a more precise alternative to maturity for measuring the life of a bond. As with many of the important innovations in finance, the investment community was slow to appreciate Macaulay's discovery of duration. It was not until the 1970s that professional investors began to substitute duration for maturity in order to measure a fixed income portfolio's exposure to interest rate risk.2 Today, duration and convexity the extent to which duration changes as interest rates change are indispensable tools for fixed income investors. In this column, I review these important concepts and show how they are applied to manage interest rate risk.
