Modified Duration Meaning, Formula, Applications, & Limitations

modified duration meaning

Conversely, if an investor owns a bond with a duration of 2, they can expect the bond’s price to decrease by 2% if interest rates increase by 1%. This is because the issuer can redeem the old bond at a high coupon and re-issue a new bond at a lower rate, thus providing the issuer with valuable optionality. Similar to the above, in these cases, it may be more correct to calculate an effective convexity. As a bond’s duration rises, its interest rate risk also rises because the impact of a change in the interest rate environment is larger than it would be for a bond with a smaller duration. Fixed-income traders will use duration, along with convexity, to manage the riskiness of their portfolio and to make adjustments to it.

  • We provide a platform for our authors to report on investments fairly, accurately, and from the investor’s point of view.
  • Duration assumes that a bond’s price rises/falls by the same amount for a given change in yields.
  • In this piece, we cover all essential concepts regarding duration with examples.
  • This formula can be used to calculate the VaR of the portfolio by ignoring higher order terms.
  • Mortgage-backed securities (pass-through mortgage principal prepayments) with US-style 15- or 30-year fixed-rate mortgages as collateral are examples of callable bonds.

It gives the dollar variation in a bond’s value per unit change in the yield. It is often measured per 1 basis point – DV01 is short for “dollar value of an 01” (or 1 basis point). The name BPV (basis point value) or Bloomberg “Risk” is also used, often applied to the dollar change for a $100 notional for 100bp change in yields – giving the same units as duration.

How is modified duration calculated?

The weight for each period is not the nominal value of the cash flow, but rather the present value of the cash flow. Modified duration evaluates how much a fund’s price varies as the interest rates or yield to maturity (YTM) change. While you don’t need to calculate the Macaulay duration for your debt funds because it’s available on the debt fund factsheet, you should be aware that a longer Macaulay duration signals more interest rate sensitivity. We sell different types of products and services to both investment professionals and individual investors. These products and services are usually sold through license agreements or subscriptions. Our investment management business generates asset-based fees, which are calculated as a percentage of assets under management.

Investors must be aware of its shortcomings when analyzing bonds with nonlinear price-yield relationships or embedded options. In such cases, considering convexity and effective duration can provide a more accurate assessment of interest rate risk. Modified duration may not be suitable for bonds with embedded options, such as callable and putable bonds. These options can alter the cash flow pattern of a bond, making its price sensitivity to interest rate changes more complex.

Modified Duration vs Macaulay Duration

This is true because, by definition, the current price of a bond is the present value of all its cash flows. The lower a bond’s coupon rate, the longer the bond’s duration will be because less payment is received before the maturity date. The higher a bond’s coupon rate, the shorter the bond’s duration will be because more payment is received before the maturity date.

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Posted: Tue, 08 Aug 2023 10:18:08 GMT [source]

Mortgage-backed securities (pass-through mortgage principal prepayments) with US-style 15- or 30-year fixed-rate mortgages as collateral are examples of callable bonds. To price such bonds, one must use option pricing to determine the value of the bond, and then one can compute its delta (and hence its lambda), which is the duration. The effective duration is a discrete approximation to this latter, and will require an option pricing model. If interest rates increase by 1%, the price of our hypothetical three-year bond will decrease by 2.67%. Conversely, if interest rates decrease by 1%, the price of the bond will increase by 2.67%. Recall that modified duration illustrates the effect of a 100-basis point (1%) change in interest rates on the price of a bond.

What is the approximate value of your cash savings and other investments?

By future cash flows of the bond, we are considering all payments made by the bond issuers to the investor (including coupon and maturity payments). Macaulay duration will be between zero years up to however many years until the bond’s maturity. It is calculated by first discounting all future cash flows to their present value. Each discounted cash flow is multiplied by the period number in which it is expected to be paid out.

The coupon rate of a bond is another factor that can affect its modified duration. Bonds with higher coupon rates typically have lower modified durations than bonds with lower coupon rates. Modified duration is useful to investors because it can help them determine how much the price of a bond will change if interest rates move by a certain amount. For example, if a bond has a modified duration of 5, and interest rates move up by 1%, the bond’s price will decrease by 5%. Duration is important for investors because it can help them understand how their bond holdings will react to changes in interest rates over a specific period of time. For example, if an investor owns a bond with a duration of 12, they can expect the bond’s price to decrease by 12% if interest rates increase by 1%.

Our authors can publish views that we may or may not agree with, but they show their work, distinguish facts from opinions, and make sure their analysis is clear and in no way misleading or deceptive. Modified duration is used to manage interest rate risk through strategies like portfolio immunization and asset-liability management. All other things being equal, a bond with a higher yield will have a lower modified duration than a bond with a lower yield. Conversely, if interest rates were to fall by 1%, the price of the bond would be expected to increase by approximately 5%.

Bond formulas

This is because higher coupon payments reduce the effective duration of a bond, as the bondholder receives more cash flows in the near term. For example, a bond with a modified duration of 5 years would be expected to experience a 5% change in price for a 1% change in yield. If interest rates were to rise by 1%, the price of the bond would be expected to decline by approximately 5%. As an example, a $1,000 bond that can be redeemed by the holder at par at any time before the bond’s maturity (i.e. an American put option). No matter how high interest rates become, the price of the bond will never go below $1,000 (ignoring counterparty risk). This bond’s price sensitivity to interest rate changes is different from a non-puttable bond with otherwise identical cash flows.

Macaulay duration is a duration measure that takes into account the time value of money. Modified duration is a duration measure that does not take into account the time value of money. Bond traders also use key rate duration to see how the value of their portfolio would change at a specific maturity point along modified duration meaning the entirety of the yield curve. When keeping other maturities constant, the key rate duration is used to measure the sensitivity of price to a 1% change in yield for a specific maturity. A limitation of both Macaulay’s Duration and Modified Duration is that they do not incorporate the impact of options.

modified duration meaning

A bond’s convexity measures the sensitivity of a bond’s duration to changes in yield. Duration is an imperfect way of measuring a bond’s price change, as it indicates that this change is linear in nature when in fact it exhibits a sloped or “convex” shape. A bond is said to have positive convexity if duration rises as the yield declines. A bond with positive convexity will have larger price increases due to a decline in yields than price declines due to an increase in yields. Positive convexity can be thought of as working in the investor’s favor, since the price becomes less sensitive when yields rise (prices down) than when yields decline (prices up). Bonds can also have negative convexity, which would indicate that duration rises as yields increase and can work against an investor’s interest.

What is Macaulay duration, and how is it calculated?

That is, a component that is linear in the interest rate changes plus an error term which is at least quadratic. This formula can be used to calculate the VaR of the portfolio by ignoring higher order terms. Quadratic terms, when included, can be expressed in terms of (multi-variate) bond convexity. The formula can also be used to calculate the DV01 of the portfolio (cf. below) and it can be generalized to include risk factors beyond interest rates. However, it is not necessary if you already know the YTM for the bond and its current price.

modified duration meaning

In contrast, if the market interest rate rises by 1%, the price of the same bond falls by 4%. The average effective maturity is the length to maturity of fixed income investments, calculated by taking the average length by weighting in a portfolio. Weighting is simply the proportion that a particular investment takes up in a portfolio according to its value. Indicated below is an example of various maturity dates but with different weightings, in a fictional portfolio, to show how we calculate average effective maturity. Yes, modified duration can be negative for bonds with cash flows that increase as interest rates rise. In this case, the bond’s price would actually increase as interest rates rise, and the modified duration would be negative.

Implications of Unchanged Repo Rate on Debt Fund Investors

However, a bond’s term is a linear measure of the years until repayment of principal is due; it does not change with the interest rate environment. Duration, on the other hand, is nonlinear and accelerates as the time to maturity lessens. A bond’s duration is easily confused with its term or time to maturity because certain types of duration measurements are also calculated in years. Duration predicts how sharply the price of a bond will change as a result of changes in interest rates. When interest rates rise, a bond’s price will fall by an amount almost equal to the change in interest rate times the duration of the bond.

  • First, as maturity increases, duration increases and the bond becomes more volatile.
  • The BPV will make sense for the interest rate swap (for which modified duration is not defined) as well as the three bonds.
  • The second part finds the weighted average time until those cash flows are paid.
  • Key rate durations require that we value an instrument off a yield curve and requires building a yield curve.

Typically, the higher the duration of the fund, the greater the sensitivity to interest rate changes. Mutual fund investments are subject to market risks, read all scheme related documents carefully. Maintaining independence and editorial freedom is essential to our mission of empowering investor success. We provide a platform for our authors to report on investments fairly, accurately, and from the investor’s point of view. We also respect individual opinions––they represent the unvarnished thinking of our people and exacting analysis of our research processes.

The bottom line is that you don’t have to shy away from using modified duration because of its complexity. There are plenty of options available to simplify the calculations for determining how interest rate changes might affect your investments. However, the formula can also be used with other financial instruments that are sensitive to interest rate changes, including mortgage-backed securities and preferred stocks. Modified duration is an unfamiliar term for many investors, but the underlying idea probably isn’t. The valuation of securities, particularly bonds, changes as interest rates change.

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