Macaulay Duration vs. Modified Duration vs. Effective Duration
Macaulay Duration measures the average time it takes to receive the bond’s total cash flow.
It is calculated by dividing the sum of all discounted cash flows by the sum of current market value of the bond.
Modified Duration, on the other hand, is similar to Macaulay Duration in that it also measures how long it takes to receive a bond’s total cash flow but it takes into account changes in interest rates.
It indicates how much a bond’s price will change when interest rates move.
Effective Duration, also known as Key Rate Durartion, measures how much a bond’s price will change when individual spot rates move and is more precise than Modified Duration since it takes into account fluctuating interest rates for each spot rate.
Key Takeaways – Macaulay Duration vs. Modified Duration vs. Effective Duration
- Macaulay Duration measures the weighted average time it takes to receive the cash flows from a bond, while Modified Duration measures the bond’s sensitivity to changes in interest rates, and Effective Duration combines both concepts by accounting for changes in interest rates and cash flows.
- For investors, Macaulay Duration is useful for determining a bond’s sensitivity to changes in interest rates and the timing of cash flows, while Modified Duration is helpful in predicting the percentage change in bond price resulting from a change in interest rates.
- In trading, the duration measures can help traders manage the risk of their bond portfolios by using duration hedging strategies, such as buying or selling futures contracts or options, to offset potential losses from changes in interest rates.
Duration vs. Maturity
Duration measures a bond’s sensitivity to changes in interest rates, while maturity is the date when the principal or initial investment amount of the bond is due for repayment.
Duration measures a bond’s price volatility in response to an interest rate change, and maturity does not take fluctuating interest rates into account.
For example, two bonds with different maturities may have the same duration, but one may be more sensitive to changing interest rates than the other depending on its maturity date.
As such, investors must consider both duration and maturity when making investment decisions.
Macaulay Duration Formula
The Macaulay Duration formula is as follows:
Macaulay Duration = (1/C) x ∑(t x CFt)
Where:
- C is the bond’s current market value
- t is the time each cash flow occurs, and
- CFt is the corresponding cash flow
Modified Duration Formula
The Modified Duration formula is:
Modified Duration = Macaulay Duration / (1 + YTM/n)
Where:
- YTM is the bond’s yield to maturity, and
- n is the number of coupon payments per year
The Modified Duration formula can be used to predict a bond’s price volatility in response to changes in interest rates.
Effective Duration Formula
The Effective Duration formula is as follows:
Effective Duration = Modified Duration x (1 + YTM/n)
Where:
- YTM is the bond’s yield to maturity, and
- n is the number of coupon payments per year
The Effective Duration formula shows the bond’s price sensitivity to a one percent change in interest rates.
Macaulay Duration Interpretation
The Macaulay Duration is a measure of the weighted average time, in years, to receive all cash flows from a bond.
It is calculated by summing the present values of each cash flow, discounted at the current yield to maturity, divided by the total present value of all cash flows.
The longer the Macaulay Duration, the more sensitive the bond will be to changes in interest rates.
To clarify this further, consider that if the price of a bond increases in response to a drop in interest rates, then its Macaulay Duration would have increased as well since it took longer for all its cash flows to be received.
Conversely, if the price of a bond decreases in response to a rise in interest rates, then its Macaulay Duration would have decreased since it took less time for all its cash flows to be received.
Modified Duration Interpretation
Modified duration is a measure used in bond trading to quantify the sensitivity of a bond’s price to changes in interest rates.
It is calculated by dividing the change in price of a bond for a one percentage point change in yield (or interest rate) by the initial bond price.
Modified duration helps investors understand how their bonds will react to changes in market conditions and can be used to make informed decisions about trading strategies.
In terms of bond trading, modified duration can be seen as an indication of how much money will be made or lost if interest rates change by 1%.
For instance, for a given 10-year zero coupon bond with 5% coupon rate, if the modified duration is 8 years, then when interest rates rise by 1%, its price decreases by 8% (8 x 0.01 = 0.08).
On the other hand, when interest rates fall by 1%, its price increases by 8%.
This therefore gives investors an idea as to how much their investment could potentially gain or lose with every small movement in yields.
Effective Duration Interpretation
Effective duration is a measurement tool used in bond trading which assesses the sensitivity of a bond’s price to changes in interest rates.
It is calculated as the percentage change in a bond’s price given a one percent change in interest rate.
This is useful for helping traders to better understand and predict how their investments are likely to react when interest rates move.
Effective duration measures how long it will take for the price of a bond to be affected by a change in interest rates.
The computation takes into account both coupon payments, which happen at regular intervals, as well as optionality associated with the bond being held to maturity (also known as an embedded option).
A longer effective duration indicates that it could take longer for changes in interest rates to affect the bond’s price significantly, while shorter durations indicate shorter reaction times.
In addition, traders can use effective duration to measure the potential impact of their investments on an overall portfolio.
A large amount of bonds with high effective durations may increase risk.
Likewise, bonds with lower effective duration can reduce risk but may not provide enough cushion against falling growth, deflationary market environments.
Accordingly, understanding effective duration helps traders make more informed decisions and balance out their investments accordingly.
Why is Modified Duration Better than Macaulay Duration?
Modified duration is a better measure of bond price sensitivity than Macaulay duration because it takes into account the effects of both coupon payments and optionality, allowing traders to improve their ability to predict portfolio performance.
Macaulay duration measures the average life of a bond, but does not consider embedded options, such as expiration or call/put features.
This means that it cannot effectively estimate how future changes in interest rates will affect the price of a bond. Modified duration, on the other hand, incorporates embedded options, so it can more accurately estimate the effect of changing interest rates on a bond’s price.
Modified duration also gives traders better insight into the risk associated with particular investments since it takes into account all factors affecting bond prices.
By incorporating embedded options, modified duration can incorporate any gains or losses from an investment – either from interest rate changes or from exercising an option – into its calculation.
This allows investors to weigh up their position more accurately by understanding how likely it is for an interest rate change to affect their profits or losses.
Overall, modified duration provides traders and investors with more accurate information about the potential risks associated with different bonds and gives them additional insight into what they should expect when dealing with those investments.
Accordingly, modified duration tends to be more useful than Macaulay duration when assessing the risks and potential returns associated with investing in bonds.
Macaulay Duration, Modified Duration, and Effective Duration – Fixed Income
FAQs – Macaulay Duration vs. Modified Duration vs. Effective Duration
What is the difference between duration and modified duration?
The difference between duration and modified duration is that modified duration takes into account the effects of both coupon payments and optionality, while regular duration only measures the average life of a bond.
Regular duration cannot effectively estimate how future changes in interest rates will affect a bond’s price, while modified duration can more accurately predict this by incorporating embedded options into its calculation.
Furthermore, modified duration provides traders with better information about potential risks associated with different bonds than regular duration does.
What does Macaulay duration tell us?
Macaulay duration measures the average amount of time necessary to receive the present value of a bond’s cash flows.
It tells us how sensitive a bond is to changes in interest rates.
Generally, the longer the Macaulay duration, the more sensitive a bond is to changes in interest rates – meaning when interest rate increases, prices for bonds with long durations will drop more than those with short durations.
Furthermore, Macaulay duration helps investors calculate return on investments and plan for future portfolio adjustments.
Is high modified duration good?
It depends on the context; high modified duration is generally perceived as a negative attribute, because it means that a bond or investment is very sensitive to changes in interest rates.
That said, when market conditions are right and an investor expects positive changes in interest rates, then having a higher modified duration can be beneficial.
Ultimately, the utility of a high modified duration depends on an investor’s strategy and risk tolerance.
Why would an analyst use effective duration instead of modified duration?
Effective duration is a more accurate measure of interest rate sensitivity than modified duration, as it takes into account the expected changes in the cash flows of a bond or investment over its life.
It also accounts for the possibility of varying periods between coupon payments.
Effective duration can provide a more precise assessment of how a bond or portfolio will respond to different types of changes in market conditions.
This makes it attractive to analysts looking for an accurate picture when making decisions about their investments.
Does higher duration mean more sensitivity?
Yes, higher duration generally means more sensitivity to changes in interest rates; as the duration of a bond or investment goes up, so does its sensitivity.
This is because when interest rates go down, bonds with higher durations experience more price increases than those with lower durations.
Conversely, when interest rates rise, higher-duration bonds experience larger price decreases.
Conclusion – Macaulay Duration vs. Modified Duration vs. Effective Duration
Macaulay duration, modified duration, and effective duration are measures used in bond trading.
Macaulay duration is the time it takes to receive the initial cash flow until all coupon payments have been made, expressed as a present value rate of return.
Modified duration, also known as modified bond duration or effective duration, measures the sensitivity of a bond’s price to changes in interest rates and is calculated by dividing Macaulay duration by one plus yield.
Effective duration is the approximate percentage change in a bond’s price given a 1% change in yield and can be useful for measuring risk.
For investors investing in bonds, understanding these measures can help to inform decision-making and understand potential risks associated with trading bonds.