Average Life
The average life is the length of time the principal of a debt issue is expected to be outstanding. Average life does not take into account interest payments, but only principal payments made on the loan or security. In loans, mortgages, and bonds, the average life is the average period of time before the debt is repaid through amortization or sinking fund payments.Investors and analysts use the average life calculation to measure the risk associated with amortizing bonds, loans, and mortgage-backed securities. The calculation gives investors an idea of how quickly they can expect returns and provides a useful metric for comparing investment options. In general, most investors will choose to receive their financial returns earlier and will, therefore, choose the investment with the shorter average life.
Average Life
Definition: Average life refers to the expected duration that the principal of a debt issuance will last. It does not include interest payments, only the principal payments on loans or securities. In loans, mortgages, and bonds, average life is the average time before the debt is repaid, considering amortization or sinking fund payments. Investors and analysts use average life calculations to assess the risk of installment bonds, loans, and mortgage-backed securities. This calculation helps investors understand how quickly they can expect returns and provides a useful metric for comparing investment options.
Origin
The concept of average life originated with the development of financial markets, particularly in the bond and loan markets. As financial instruments became more complex, investors needed a method to evaluate the timing and risk of their returns. The calculation of average life was introduced and became an important metric for assessing the risk and return of debt instruments.
Categories and Characteristics
Average life can be applied to different types of financial instruments, including:
- Bonds: The average life of a bond refers to the average time before all principal payments are completed.
- Loans: The average life of a loan refers to the average time before all principal payments are completed, typically used to assess the risk and return of the loan.
- Mortgage-Backed Securities (MBS): The average life of these securities refers to the average time before all principal payments are completed, considering the possibility of prepayments.
These instruments' average life helps investors understand the timing of their returns and provides a useful metric for comparing different investment options.
Specific Cases
Case 1: Suppose an investor purchases an installment bond that pays part of the principal and interest annually. By calculating the average life, the investor can understand the average time before all principal payments are completed, thus assessing the bond's risk and return.
Case 2: An investor buys a mortgage-backed security (MBS), where the principal payment timing depends on the borrowers' prepayment behavior. By calculating the average life, the investor can estimate the average time before all principal payments are completed, better assessing the security's risk.
Common Questions
Question 1: Why does average life not include interest payments?
Answer: Average life focuses on the timing of principal payments because the recovery time of the principal directly impacts the investor's return and risk assessment.
Question 2: What is the difference between average life and duration?
Answer: Duration measures the sensitivity of a bond's price to changes in interest rates, while average life measures the timing of principal payments. They focus on different aspects.
