Modified Duration

Modified duration is a measure of how much the price of a bond will change in response to a change in interest rates. It is calculated by taking the duration of the bond and multiplying it by the bond's yield to maturity.

The duration of a bond is a measure of how long it will take for the bond to pay back its principal. It is calculated by taking the present value of all of the bond's cash flows and dividing it by the bond's price.

The yield to maturity of a bond is the interest rate that the bond would have to pay if it were held to maturity. It is calculated by taking the sum of all of the bond's cash flows and dividing it by the bond's price.

Modified duration is a useful tool for investors because it can help them to estimate how much the price of a bond will change if interest rates change. For example, if a bond has a modified duration of 5 years and interest rates increase by 1%, the price of the bond will decrease by approximately 5%.

Modified duration is also used by bond traders to manage their risk. By understanding how the price of a bond will change in response to a change in interest rates, traders can make informed decisions about when to buy and sell bonds.

It is important to note that modified duration is only an approximation of how the price of a bond will change in response to a change in interest rates. The actual change in price will depend on a number of factors, including the coupon rate of the bond, the term of the bond, and the volatility of interest rates.

Despite its limitations, modified duration is a valuable tool for investors and traders who want to understand the relationship between interest rates and bond prices.