Modified duration is a concept that interest rates and bond prices move in opposite directions. It tells you how sensitive a bond is to interest rate changes. It is expressed in a formula that expresses the measurable change in the value of a security in response to a change in interest rates.
Key points about modified duration:
A “Bond” with a lower “modified duration” implies that the “returns” are more from accrual income than from capital gains.
A “Bond” with a higher “modified duration” implies that the “returns” are more from capital gains than from accrual income.
For example an investor has a bond of 2 years maturity with 5% annual interest and with a yield to maturity of 5%. If the current price of the above bond is Rs.1000/-, then
PV of first payment will be (1000×0.05) ÷ (1+0.05)=47.62
PV of the second payment, including the maturity amount, would be
[1000 + (1000 ×0.05)] ÷ (1 + 0.05%)^2) = 1050/1.1025 = 952.38
Therefore, Macauley duration would be [(47.62 x 1) + (952.38 x 2)]÷ (47.62 + 952.38), =1952/1000= 1.952.
The modified duration is 1.952÷1.05=1.859,
Modified Duration = Macaulay Duration/ (1+y/m), where ‘y’ is the yield (5%), ‘m’ is the number of times compounding occurs in a year.i.e. 1 (annual interest)
Related article: What is Macaulay Duration?
The marginal cost of capital (MCC) is the total combined cost of debt, equity, and…
The weighted average cost of capital (WACC) is the average rate that a business pays…
The Reserve Bank of India (RBI) defines a personal loan as a type of unsecured…
A share is a unit of ownership in a company and has an exchangeable value…
The cost of debt is the interest rate a company pays on its debt, and…
This article explains the assumptions and key aspects of approaches to capital structuring, including the…