Can someone give a clear definition on the difference between the two. Just had a question that asked what the percent change in price would be given a 75bps decrease in the yield. Question gave effective duration of 16.9 years and modified duration of 18 years. Correct answer was 16.9 x .0075. Why the effective duration on not the modified duration, which is the change in price for a 100bps change in yield?!
modified duration takes into account YTM and time to expiration. modified does not take into account embedded options effective duration does and is a better measure of duration for bonds with embedded options
Hey, Macaulay duration is based on the expected cash-flows for an option free bond. Modified duration is based on the Macaulay duration and additionally takes into account the YTM of the bond. Note that modified duration assumes that the cash-flows on the bond won’t change. Effective duration takes into account the changes in cash-flows due to embedded options. Hope this makes it a tad clearer…
Got it. Was just thrown by the question, since there was no comment on the bond having any option features. (Fortunately based on the options in the multiple choice, only effective duration was possible).
You can also note that we are not responsible for knowing how to calculate modified or Macaulay so process of elimination leads to calculation using the effective duration figures.