Modified Duration
Modified duration is an indicator that measures the sensitivity of a bond's price to changes in interest rates. It represents the percentage change in the bond's price for a 1% change in interest rates. The higher the modified duration, the more sensitive the bond's price is to changes in interest rates.
Modified Duration
Modified duration is a measure of a bond's price sensitivity to changes in interest rates. 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 changes in interest rates.
Origin
The concept of modified duration originates from duration, first introduced by American economist Frederick Macaulay in 1938. Duration was initially used to measure the weighted average time to maturity of a bond. Modified duration builds on this by considering the impact of interest rate changes on bond prices.
Categories and Characteristics
There are several types of duration:
- Macaulay Duration: The original concept of duration, used to measure the weighted average time to maturity of a bond.
- Modified Duration: Builds on Macaulay duration by considering the impact of interest rate changes on bond prices.
- Effective Duration: Used to measure the sensitivity of bonds with embedded options to changes in interest rates.
The key characteristic of modified duration is its ability to more accurately reflect a bond's price sensitivity to small changes in interest rates.
Specific Cases
Case 1: Suppose a bond has a modified duration of 5 years and the current market interest rate is 3%. If the market interest rate rises by 1% to 4%, the bond's price is expected to decrease by approximately 5%.
Case 2: Another bond has a modified duration of 2 years and the current market interest rate is 3%. If the market interest rate falls by 1% to 2%, the bond's price is expected to increase by approximately 2%.
Common Questions
Q: What is the difference between modified duration and duration?
A: Duration primarily measures the weighted average time to maturity of a bond, while modified duration builds on this by considering the impact of interest rate changes on bond prices.
Q: Is a higher modified duration better?
A: A higher modified duration means the bond price is more sensitive to changes in interest rates. This is beneficial when interest rates fall but poses a greater risk of price volatility when interest rates rise.
