Modified Duration
What Is Modified Duration?
Modified duration is a measure used in bond investing to estimate how sensitive a bond’s price is to changes in interest rates. It indicates the percentage change in a bond’s price for a one percent change in interest rates.
Modified duration helps investors evaluate interest rate risk in fixed-income investments.
Why It Matters
Interest rate movements significantly affect bond prices. Modified duration allows investors to estimate how much a bond’s value may rise or fall when interest rates change.
Understanding duration helps investors manage risk in bond portfolios.
How Modified Duration Works
Modified duration is calculated using a bond’s cash flows and yield.
Key concepts include:
- higher duration means greater price sensitivity
- longer-term bonds typically have higher duration
- lower duration means less exposure to interest rate changes
Investors often compare duration across bonds to assess interest rate risk.
Example
If a bond has a modified duration of 5, its price may decline about 5 percent if interest rates increase by 1 percent.
Modified Duration vs Macaulay Duration
- Macaulay duration measures the weighted average time to receive a bond’s cash flows.
- Modified duration adjusts that measure to estimate price sensitivity to interest rate changes.
FAQs About Modified Duration
Why is duration important for bond investors?
It helps estimate how bond prices respond to interest rate movements.
Do higher-duration bonds carry more risk?
Yes. They are more sensitive to interest rate changes.
Is duration the same as maturity?
No. Maturity is the bond’s end date, while duration measures interest rate sensitivity.
Related Terms
