Friday, April 15, 2005

Equity Duration Of The S&P 500 Index

The duration of bond measures the price sensitivity of the bond to the interest rates. Let’s suppose that the duration of a bond is 2 years. If the interest rate falls by 1% then the price of the bond will rise by 2%. If the interest rate goes up by 1% then the price of the bond will fall by 2%.

What if we had a similar measure for stocks? What if we can come up with the equity duration, which will tell us the interest rate sensitivity of the stock to the rising or falling interest rate.

The Standard and Poor’s (S&P) has done just that. They have “developed a simple model of equity duration that uses the dividend discount model and incorporates the sensitivity of growth” to interest rates. Duration is judged higher for high growth stocks. The S&P does recognize that the “duration estimation is an evolving science”. They intend to publish this data every year to provide the perspective on the equity valuations.

So, What is the duration of S&P 500 index? This is what the S&P estimates: “We estimate the duration of the S&P 500 index to be 19 years at the end of third quarter of 2004. It has risen from its level of 15 years at the middle of 2003, suggesting that the market has become more rate-sensitive. However, duration of the index is still below the 22-23 years figure seen in 1999”.

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