Chartered Financial Analyst (CFA) Practice Exam Level 2

What is Macaulay Duration?

1. The time-weighted average term to maturity of cash flows of a bond.

2. The sensitivity of bond price to yield changes.

3. The total cash flow received from a bond.

4. The anticipated return on a bond investment.

The correct answer is: The time-weighted average term to maturity of cash flows of a bond.

Macaulay Duration is defined as the time-weighted average term to maturity of the cash flows from a bond. This means it considers both the timing and the present value of each cash flow associated with the bond, including coupons and the principal repayment at maturity. By giving more weight to cash flows that occur sooner in time, Macaulay Duration effectively measures how long it takes, in terms of time, for the investor to receive the present value of the bond's cash flows. This measure is crucial for understanding interest rate risk; a bond with a longer Macaulay Duration is generally more sensitive to interest rate changes. Thus, it helps investors assess how changes in interest rates might impact the bond's price over time. The other options address different aspects of fixed-income investments. While sensitivity to price changes is related, that concept specifically refers to the price volatility of a bond in reaction to interest rate changes, rather than the weighted average time of cash flows. Total cash flow received from a bond pertains to the actual monetary return rather than the timing of those returns. Finally, anticipated return is associated with investment performance rather than duration, which solely focuses on the timing of cash flows rather than the overall return on investment.