Modified Duration

Definition

Modified duration is a measure of a bond's price sensitivity to interest rate changes. It indicates the percentage change in a bond's price for a 1% change in interest rates. The higher the modified duration, the more sensitive the bond price is to interest rate changes.

Origin

The concept of modified duration originates from the duration theory, first introduced by American economist Frederick Macaulay in 1938. As financial markets evolved, modified duration was introduced to more accurately reflect a bond's price sensitivity to interest rate changes.

Categories and Features

Modified duration is primarily used for fixed-income securities, especially bonds. Its feature is to help investors assess interest rate risk. Bonds with higher modified duration will see a larger price decrease when interest rates rise, and vice versa. It is often used in conjunction with other metrics like duration and convexity to comprehensively assess a bond's interest rate risk.

Case Studies

Case Study 1: Suppose a company issues a 10-year bond with a modified duration of 8. If market interest rates rise by 1%, the bond's price is expected to decrease by approximately 8%. Case Study 2: An investor holds a bond portfolio with a modified duration of 5. When interest rates decrease by 0.5%, the portfolio's value is expected to increase by about 2.5%. These cases demonstrate the practical application of modified duration in assessing the impact of interest rate changes on bond prices.

Common Issues

Investors often confuse modified duration with duration. Modified duration accounts for changes in yield, whereas duration is merely a time-weighted measure of cash flows. Additionally, modified duration is not applicable to all types of bonds, especially those with embedded options.