MODIFIED DURATION Meaning and
Definition
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Modified duration is a financial metric used in bond investing to measure the price sensitivity of a bond or fixed-income security to changes in interest rates. It quantifies and expresses the percentage change in the market value of a bond for a given change in interest rates.
Modified duration takes into account the concept of time, unlike Macaulay duration which only considers the bond's time to maturity. It calculates the bond's weighted average time to receive the bond's cash flows, incorporating the present value of each cash flow and the time at which it is expected to be received.
The modified duration formula takes into consideration both the coupon payments received on the bond and the final principal payment at maturity, discounting each cash flow to its present value using the interest rate. The calculation accounts for the fact that the present value of these cash flows will change as interest rates fluctuate.
The modified duration figure is expressed in terms of a number of years, and it reflects the change in price for a 1% change in yield. For example, if a bond has a modified duration of 5 years, it indicates that the bond's price will change by approximately 5% for every 1% change in interest rates. Thus, the higher the modified duration, the greater the bond's price sensitivity to interest rate changes.
Etymology of MODIFIED DURATION
The word "modified" in modified duration refers to a variation or adjustment made to the typical or standard duration measurement in finance.
The term "duration" itself comes from the Latin word "dūrātiō", meaning "length" or "duration". It was first introduced in the field of finance by Frederick Macaulay in his 1938 book "The Theory of Interest".
The modification of duration is based on the need to account for changes in interest rates and cash flows associated with bonds or other fixed income securities. Modified duration is a measure of the price sensitivity or risk associated with a bond when interest rates change.
Overall, "modified duration" is a combination of the original concept of duration with adjustments made to better reflect the impact of interest rate changes on a bond's value.
