Fixed Income Investments  Effective, Modified, and Macaulay Duration
Effective Duration
Duration is the approximate percentage change in price for a 100 basis point change in rates. To compute duration, you can apply the following equation that was presented earlier in the guide.
Price if yield decline  price if yield rise / 2(initial price)(change in yield in decimal)
Let's make:
âˆ†y = change in yield in decimal (âˆ† = "delta")
V1 = initial price
V2 = price if yields decline by âˆ†y
V3 = price if yields increase by âˆ†y
Duration = V2  V3 / 2(V1)(? y)
Example:
Stone & Co 9% of 10 are option free and selling at 106 to yield 8.5%. Let's change rates by 50 bps. The new price for the increase in 50 bps would be 104 and the new price for a decrease in rates would be 109. Then:
Answer:
Duration = 109  104 / 2 *(106) * (.005)
Duration = 5 / 1.06
Duration = 4.717
This means that for a 100 basis point change, the approximate change would be 4.717%
Price Change Given the Effective Duration and Change in Yield
Once you have computed the effective duration of a bond it is easy to find the approximate price change given at change in yield.
Formula 14.13
Approximate Percent Price change =  duration x change in yield x 100 
Example:
Using the duration for 4.717% obtained from the previous example, let's see the approximate change for a small movement in rates such as a 20 bps increase.
Percentage Price Change =  4.717 x (+0.0020) x 100 = .943%
And for a large change, a 250 bps increase:
Percentage Price Change = 4.717. (+0.0250) x 100 = 11.79%
As noted before, these changes are estimates. For small changes in rates, the estimate will be almost dead on. For larger movements in rates, the estimate will be close but will underestimate the new price of the bond regardless of whether the movement in rates is up or down.
Modified Duration
Modified duration is the approximate percentage change in a bond's price for a 100 basis points change in yield, assuming that the bond's expected cash flow does not change when the yield changes. This works for optionfree bonds such as Treasuries but not with optionembedded bonds because the cash flows may change due to a call or prepayment.
Effective Duration
Effective duration takes into account the way in which changes in yield will affect the expected cash flows. It takes into account both the discounting that occurs at different interest rates as well as changes in cash flows. This is a more appropriate measure for any bond with an option embedded in it.
Macaulay Duration
In order to better understand Macaulay duration, let's first turn to the modified duration equation:
Formula 14.14
modified duration = 1/(1+yield/k)[1 x pvcf1 + 2Â x pvcf2 +...+n x pvcfn / k x Price 
Where:
k = the number of periods: two for semiannual, 12 for monthly and so on.
n = the number of periods to maturity
yield = YTM of the bond
pvcf = the present value of cash flows discounted at the yield to maturity.
The bracket part of the equation was developed by Frederick Macaulay in 1938 and is referred to as Macaulay Duration.
So Modified duration = Macaulay's Duration/ (1 + yield/k)
Macaulay's duration gives the analysis a short cut to measure modified duration. But because modified duration is flawed by not incorporating the change in cash flows due to an embedded option, so are Macaulay durations.
When is Effective Duration a Better Measure?
When a bond has an embedded option, the cash flows can change when interest rates change because of prepayments and the exercise of calls and puts. Effective duration takes into consideration the changes in cash flows and values that can occur from these embedded options.
Why is duration the best interpretation of a measure of the sensitivity of a bond or portfolio to changing interest rates?
As expressed throughout this guide, duration gives an approximate percentage change for a 100 basis point change in rates. Once you understand duration, it is a quick way to calculate the change in a bond's value. It also allows an investor to get a "feel" for the price change. For example, you can tell a client that the duration of measure of 7 for their portfolio would equal roughly a 7% change in their portfolio's value if rates change, plus or minus 100 basis points. It also allows a manager or investor a way to compare bonds regarding the interest rate risk under certain assumptions.
A portfolio's duration is equal to the weighted average of the durations of the bonds in the portfolio. The weight is proportional to how much of the portfolio consists of a certain bond.
Formula 14.15
Portfolio Duration = w_{1}D_{1} + w_{2}D_{2} ...+ w_{k}D_{k} 
Example:
Let's take 3 bonds:
$6,000,000 market value of Stone & Co 7% of 10 with duration of 5.5
$3,400,000 market value of Zack Stores 5% or 15 with duration of 7.8
$1,535,000 market value of Yankee Corp. 9% or 20 with duration of 12
Total market valve of $10,935,000
Answer:
First let's find the weighted average of each bond
Stone & Co. weighted average is 6,000,000 / 10,935,000 = .548
Zack Stores weighted average is 3,400,000 / 10,935,000 = .311
Yankee Corp. weighted average is 1,535,000 / 10935,000 = .14
So the portfolio duration = .548(5.5) + .311(7.8) + .14 (12)
= 7.119
This means that if rates change by 100 bps the portfolio's value will change by approximately by 7.119%. Keep in mind that the individual bonds will not change by this much because each will have their own duration.
You can also use this to figure out the dollar amount of the change. This is done by using the dollar duration equation and adding up the change for all of the bonds in the portfolio.
Going back to our example of those three bonds and a 50 bps yield change.
Percentage price change = duration x change in yield x market value
Stone & Co = 5.5 x .005 x 6,000,000 = 165,000
Zack Stores = 7.8 x .005 x 3,400,000 = 132,600
Yankee Corp = 12 x .005 x 1,535,000 = 92,100
So the dollar change for a 50 bp change would be equal to approximately $389,700
Limitations of the Portfolio Duration Measure
The primary limitation of this measure is that each of the bonds in the portfolio must change by the 100 or 50bps, or there must be a parallel shift in the yield curve for the duration measure to be useful.

Financial Advisors
Why You Should Avoid Fixating on Bond Duration
Financial advisors and their clients should then focus on a bond fundâ€™s portfolio rather than relying on any single metric like duration. 
Bonds & Fixed Income
The Basics Of Bond Duration
Duration tells investors the length of time it will take a bond's cash flows to repay the investor the price he or she paid for the bond. A bond's duration is stated as a number of years and ... 
Options & Futures
Immunization Inoculates Against Interest Rate Risk
Bigmoney investors can hedge against bond portfolio losses caused by rate fluctuations. 
Bonds & Fixed Income
What Does Duration Mean?
Duration measures a fixedincomeâ€™s sensitivity to changes in interest rates. 
Mutual Funds & ETFs
3 LongTerm Bond Mutual Funds to Avoid in 2016 (GEDZX, PLRIX)
Explore longterm bond mutual funds to avoid in 2016, and learn how rising rates may affect some of the best performing bond funds of the last five years. 
Economics
The Effect of Fed Fund Rate Hikes on Your Bond Portfolio
Learn how an increase in the federal funds rate may impact a bond portfolio. Read about how investors can use the duration of their portfolio to reduce risk. 
Bonds & Fixed Income
Advanced Bond Concepts: Formula Cheat Sheet
Below is our formula cheat sheet for bond analysis. Actual/Actual Day Count (Nonleap year) Actual/Actual Day Count (Leap year) ... 
Investing
Ideas for Your Bond Portfolio When Rates Rise
It has been nearly 10 years since the Fed last raised interest rates, and though the central bank didnâ€™t hike rates this month, they look to be coming. 
Mutual Funds & ETFs
The Top 5 Bond Mutual Funds for 2016
Learn about bond mutual funds that investors may want to consider for 2016. Understand why the risk of rising interest rates is a concern heading into 2016. 
Bonds & Fixed Income
Simple Math for FixedCoupon Corporate Bonds
A guide to help to understand the simple math behind fixedcoupon corporate bonds.

Dollar Duration
Dollar duration measures the dollar change in a bond's value ... 
Effective Duration
A duration calculation for bonds with embedded options. Effective ... 
Empirical Duration
The calculation of a bond's duration based on historical data. ... 
Duration
A measure of the sensitivity of the price (the value of principal) ... 
Macaulay Duration
The weighted average term to maturity of the cash flows from ... 
Key Rate Duration
Holding all other maturities constant, this measures the sensitivity ...

Which is a better metric, modified duration or Macaulay duration?
Learn why the modified duration is a more useful metric than the Macaulay duration, and understand how the measures are different ... Read Answer >> 
What is the average profit margin of a company in the chemicals sector?
Learn more about the Macaulay duration and the modified duration, how to calculate a bond's Macaulay duration and modified ... Read Answer >> 
What is the risk return tradeoff for bonds?
Find out more about the Macaulay duration and modified duration, how to calculate them and the difference between the Macaulay ... Read Answer >> 
How can I use a bond's duration to predict its return?
Learn how the concept of duration is used to determine when future cash flows for a bond will equal the amount paid for the ... Read Answer >> 
For what financial instruments is a modified duration relevant?
Find out about modified duration, financial instruments the modified duration is used for and how to calculate the modified ... Read Answer >> 
What is the formula for calculating the capital to risk weight assets ratio for a ...
Learn about the Macaulay duration and zerocoupon bonds, the formula used for the calculation and how to calculate the Macaulay ... Read Answer >>