Why is modified duration better than maturity?
Modified duration is a slightly more involved calculation that takes into account the effects of interest-rate movements. Effective duration is another, still-more complicated measure used to assess interest-rate sensitivity when callable securities (those that may be paid off before maturity) are involved.
What is the formula for modified duration?
To find the modified duration, all an investor needs to do is take the Macaulay duration and divide it by 1 + (yield-to-maturity / number of coupon periods per year). In this example that calculation would be 2.753 / (1.05 / 1), or 2.62%.
Does duration increase with time to maturity?
Duration is inversely related to the bond’s coupon rate. Duration is inversely related to the bond’s yield to maturity (YTM). Duration can increase or decrease given an increase in the time to maturity (but it usually increases).
What is the duration of a bond whose coupon rate is 6% and has a maturity of 6 years if the yield to maturity is 8 %?
The modified duration for this bond, with a yield to maturity of 6% for one coupon period, is 4.59 years (4.87/(1+0. 06/1). Therefore, if the yield to maturity increases from 6% to 7%, the duration of the bond will decrease by 0.28 years (4.87 – 4.59).
What is difference between duration and modified duration?
Duration measures a bond’s or fixed income portfolio’s price sensitivity to interest rate changes. Macaulay duration estimates how many years it will take for an investor to be repaid the bond’s price by its total cash flows. Modified duration measures the price change in a bond given a 1% change in interest rates.
What is the relationship between maturity and duration?
In plain English, “duration” means “length of time” while “maturity” denotes “the extent to which something is full grown.” When bond investors talk about duration it has a very specific meaning: The sensitivity of a bond’s price to changes in interest rates.
How does Modified duration work?
Modified duration is a measure of a bond price sensitivity to changes in its yield to maturity. It is calculated by dividing the Macaulay’s duration of the bond by a factor of (1 + y/m) where y is the annual yield to maturity and m is the total number of coupon payments per period.
How do I calculate modified duration in Excel?
The formula used to calculate a bond’s modified duration is the Macaulay duration of the bond divided by 1 plus the bond’s yield to maturity divided by the number of coupon periods per year. In Excel, the formula used to calculate a bond’s modified duration is built into the MDURATION function.
What is the difference between duration and modified duration?
1. Duration or Macaulay Duration refers to measurement of weighted average time before having the cash flow, while Modified Duration is more on the percentage change in price in terms of yields.
How does maturity affect duration?
Certain factors can affect a bond’s duration, including: Time to maturity: The longer the maturity, the higher the duration, and the greater the interest rate risk. A bond that matures faster—say, in one year—would repay its true cost faster than a bond that matures in 10 years.
What is bond duration vs maturity?
Why do we use modified duration?
The modified duration provides a good measurement of a bond’s sensitivity to changes in interest rates. The higher the Macaulay duration of a bond, the higher the resulting modified duration and volatility to interest rate changes.
How is modified duration related to interest rates?
Modified duration illustrates the concept that bond prices and interest rates move in opposite directions – higher interest rates lower bond prices, and lower interest rates raise bond prices. The formula for modified duration is as follows:
What is the definition of a modified duration?
Modified duration is an extension of something called the Macaulay duration, which allows investors to measure the sensitivity of a bond to changes in interest rates.
How is modified duration used in bond valuation?
Modified duration, a formula commonly used in bond valuations, expresses the change in the value of a security due to a change in interest rates. Floating Interest Rate A floating interest rate refers to a variable interest rate that changes over the duration of the debt obligation. It is the opposite of a fixed rate.
What are the different types of durations in fixed income?
A full analysis of the fixed-income asset must be done using all available characteristics. CFI’s Fixed Income Fundamentals Course covers the essential topics for fixed-income valuation. The duration metric comes in several modifications. The most common are the Macaulay duration, modified duration, and effective duration.