What is the difference between modified duration and Macaulay duration?

What is the difference between modified duration and Macaulay duration?

Modified Duration: An Overview. The Macaulay duration calculates the weighted average time before a bondholder would receive the bond’s cash flows. Conversely, the modified duration measures the price sensitivity of a bond when there is a change in the yield to maturity.

What does the Macaulay duration tell us?

Macaulay duration is the weighted average of the time to receive the cash flows from a bond. It is measured in units of years. Macaulay duration tells the weighted average time that a bond needs to be held so that the total present value of the cash flows received is equal to the current market price paid for the bond.

What is the difference between modified and effective duration?

Effective duration differs from modified duration because the latter measures the yield duration – the volatility of the interest rates in terms of the bond’s yield to maturity – while effective duration measures the curve duration, which calculates the interest rate volatility using the yield curve.

Why is modified duration better?

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.

Is Modified duration accurate?

For a small change in interest rates, modified duration provides a good approximation of the actual change in value. As the change in interest rates gets larger, the duration approximation has larger errors. The second derivative term, or convexity, is often used as a way to improve the accuracy of the approximation.

What is Macaulay duration in mutual fund?

Macaulay Duration is a measure of how long it takes for the price of a bond to be repaid by its internal cash flows. It measures the change in the value of a fixed income security that will result from a 1% change in the interest rate.

Is effective duration the same as Macaulay duration?

3. Effective Duration. Effective duration is a measure of the duration for bonds with embedded options (e.g., callable bonds). Unlike the modified duration and Macaulay duration, effective duration considers fluctuations in the bond’s price movements relative to the changes in the bond’s yield to maturity (YTM).

Is high modified duration good?

So higher the modified duration, higher is the risk of price fluctuation and lower the modified duration, the lower would be the price fluctuation. Basically, the price of a bond and the interest rate have inverse relationship, i.e. if the interest rates rise, the price of the bond would fall and vice versa.

Why is modified duration not accurate?

The slope of the line is the instantaneous change in price for an infinitely small change in the yield. Modified Duration loses accuracy on larger changes in yield due to the convexity of the curve. Modified duration is a first-order linear approximation of the change.

Why is modified duration negative?

The price-yield relationship is negatively correlated; when prices go down, the implied yield goes up. The minus sign allows the modified duration to be positive for a normal bond.

What is modified duration in mutual fund?

Modified duration is a formula that expresses the measurable change in the value of a security in response to a change in interest rates. Modified duration follows the concept that interest rates and bond prices move in opposite directions.

What affects Macaulay duration?

Factors Affecting Duration A bond’s price, maturity, coupon and yield to maturity all factor into the calculation of duration. All else being equal, duration increases as maturity increases. As interest rates increase, duration decreases and the bond’s sensitivity to further interest rate increases goes down.

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