What is Duration Drift?
Duration drift represents the change in duration as a result of the passage of time. It is a problem in asset-liability management, which makes it necessary to regularly monitor and recalculate the duration of a financial instrument.
To better understand duration drift and its effects, you need to first understand what duration is and how it is applied in asset-liability management.
Introduction of Duration Drift
Duration drift represents the change of duration as a result of the passage of time. It causes a problem of matching the duration of the set of assets and liabilities for the asset-liability management purpose. A mismatch of duration leads to the exposure to interest rate risk.
If the duration of assets is greater (smaller) than that of liabilities, an increase (decrease) in the market interest rate leads to a larger decrease (smaller increase) in the value of assets than the value of liabilities, which causes a loss in the value of the portfolio.
Duration drift causes a mismatch of duration in several situations. The most common one is when the portfolio assets and liabilities come with different coupon rates. As mentioned above, the duration and term to maturity do not decrease at the same rate for coupon bonds.
The duration of the bond with a higher coupon rate moves slower as the change of term to maturity. For example, a company owns a portfolio of assets with a 4% coupon and a portfolio of liabilities with an 8% coupon.
The durations of assets and liabilities are managed to match at the original point of time, but as time passes and term to maturity decreases, the duration of the assets declines slower than that of the liabilities. In such a situation, if the interest rate rises, the assets lose more value than the liabilities, and the value of the company falls.