Duration vs Modified Duration
Duration and modified duration are terms that are often encountered in the field of investments, especially, stocks, and bonds. To be an efficient investor, one needs to know the difference between the two. Duration refers to cash flow of any finances. It is a very important factor that affects yield or return on investments. It is a number of things in itself as it can be the time expected before you receive repayments, and it could also be the price change in percent. This is what creates confusion, and hence to solve this problem there are two terms, namely Duration (Macaulay Duration), and Modified Duration.
Macaulay Duration, invented by Fredrick Macaulay in 1938, is also known as simply Duration. It refers to the weighted average time before repayments are received. It is applied only to investments with fixed rate of returns
Modified Duration is a tool that measures change in price (percentage) relative to a unit change in yield. It is also called a logarithmic derivative of prices in terms of yield, or simply price sensitivity. It is dependent only upon yield, irrespective of whether the investment is a fixed return one or not. It is used to check the sensitivity of a bond price to finite interest rate. As it is more flexible, Modified Duration is more popular than Macaulay Duration.
Normally, if the yield is compounded continuously, the values we arrive at using both durations is same. The differences arise only when the yield is compounded periodically, though the results are still comparable.
It is prudent for an investor to be able to calculate both the durations on a bond or a stock to be able to take correct and less risky investment decisions.
• Duration and Modified Duration are investment tools to help investors
• Duration measures average weighted time before repayments, while Modified Duration is focused more on change in price percentage relative to yields
• Modified Duration being more flexible, is used more often than Duration
• Duration requires cash flow to be fixed while Modified Duration applies to other situations also