Modified duration is a formula that expresses the measurable change in the value of a security in response to a change in interest rates. Modified duration follows the concept that interest rates and bond prices move in opposite directions. This formula is used to determine the effect that a 100-basis-point (1%) change in interest rates will have on the price of a bond.
Modified duration can be calculated manually as follows:
Modified duration is an extension of the Macaulay duration, which allows investors to measure the sensitivity of a bond to changes in interest rates. Macaulay duration calculates the weighted average time before a bondholder receives the bond’s cash flows. In order to calculate modified duration, the Macaulay duration must first be calculated.
Formula for Macaulay duration is –