Duration vs. Modified Duration

Difference Between Duration and Modified Duration

Modified duration and duration are encountered in the investment field, particularly bonds & stocks. To be an effective investor, one must know the difference between them. Duration is related to financial cash flow. This is an important factor affecting the return on investment. It is a number of things in them as can be the period expected before you get refunds plus it could also be the price change in the percent. This creates confusion. To avoid it there are two words, duration (the Macaulay duration) and the modified duration.

Macaulay duration

The Macaulay duration, invented by Fredrick Macaulay in 1938, is simply called duration. It refers to the weighted average time before the reception of refunds. It is applicable to investments with fixed rates of return.

Modified Duration

The modified duration is a way to measure the change in price (percentage) in respect to a unit change in production. Also it is called logarithmic derivative of rates in terms of returns, or simply the sensitivity of prices. It depends only on the returns, regardless of whether the investment is a fixed return or not. It is used to check the sensitivity of bond prices to predetermined rate of interest.  Modified duration is more popular than the Macaulay duration because it is more flexible.

In general, if the return is compounded constantly, the values we get using both these durations are same. Differences occur only when the return is made periodically, although the results remain comparable.

It is prudent for an investor to be able to calculate these durations on a stock or bond to be able to make correct decisions that prove to be less risky investment.

 

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