Modified duration indicates the percentage change in the price of a bond for a given change in yield. It is a more adjusted measure of Macaulay duration that produces a more accurate estimate of bond price sensitivity.
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m is the # of compounding period per year.
The relationship between percentage changes in bond prices and changes in bond yields is approximately:
Example
Assume a 5-year bond, providing a coupon of 5%, with a current yield of 7%.
The Duration of the bond is 4.52.
The modified duration will be:
MD = 4.52/(1.07) = 4.23
Interpretation
The modified duration of the bond is 4.23. This means that the price of the bond will increase to 4.23 with a 1% or 100 basis point increase in interest rates.
Modified duration provides a good indication of a bond's sensitivity to a change in interest rates. The more your duration changes with a 1% increase in interest rates, the more volatility your bond will exhibit.
