Difference Between Duration and Modified Duration

Duration vs. Modified Duration

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If you are into business or finance and you want to make it big time investing your money on stocks, then it is important that you are familiar with yields, bonds and cash flow. You must be able to monitor your income properly so as to be assured that you are not bankrupting your own investment. To be able to measure the time of payment and yields in prices, then you must familiarize yourself with duration such as the Macaulay Duration and Modified Duration.

Duration is a financial term referring to the cash flow of finances. Examples of these are bonds, stocks and other business shares. Durations are also very important factors in determining yields on prices and other percentages in the field of finance. Duration can be the time expected before the repayment is received or it could also mean the percent of change in price. This fact sometimes leads into confusion. That is why duration is classified into two, Macaulay Duration and Modified Duration.

Macaulay Duration or otherwise known as duration refers to the weighted average time before repayment or the time when cash flow is received. This concept was named after the man who introduced it to the world of finance, Frederick Macaulay. This duration takes years to measure. Macaulay Duration can only be extended on instruments with fixed cash flows.

On the other hand, Modified Duration is about the percentage change in price for a unit change in yield, it also refers to the price sensitivity. It is defined as the logarithmic derivative of prices with respect to yield. Modified Duration depends to none other than the yields, whether or not the instruments have fixed cash flow or none. This is useful when it will be used to measure the sensitivity of a bond’s market price to a finite interest rate such as yield movement. Compared to Macaulay Duration, Modified Duration is used more and often.

Both these durations will come to a point wherein they will be equal numerically, like for example when yields compound continuously. However, when yields are periodically compounded these durations will differ in a small amount, but they will still be related a little bit.

It is very important to familiarize yourself with these durations because it can help you a lot in taking the right risk when you invest on business related to stocks. These durations will be able to give you the right decisions while following your intuition.

Summary:

1.

Duration or Macaulay Duration refers to measurement of weighted average time before having the cash flow, while Modified Duration is more on the percentage change in price in terms of yields.
2.

Modified Duration is used more than duration.
3.

Modified Duration cover a wider range of application than duration.
4.

In duration, cash flow must be fixed while Modified Duration does not require a fixed cash flow
5.

Macaulay takes years to measure while Modified Duration focuses more on the yields

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