At the end of this session, you should be able to understand the difference between duration and modified duration and how they are related as measures of the interest rate risk of a bond. Examples used throughout this session are based on fixed rate or nominal bonds for ease of calculation but floating rate note duration and modified duration are calculated using the same principles.
Duration and modified duration - useful tools for comparing bonds
Duration measures the average term to maturity of a bond, weighted by the present value of each cashflow. It is also commonly referred to as “Macaulay Duration”. It is a more meaningful measure of a bond than simply looking at the term to maturity of the bond, as it takes into account the coupon payments that are made. If a bond is a zero-coupon bond, then the duration is equal to the term to maturity.
Mathematically, duration is represented as follows