Effective duration vs Modified duration

Discussion in 'P2.T5. Market Risk (25%)' started by sridhar, Oct 3, 2008.

  1. sridhar

    sridhar New Member

    I am sort of struggling with understanding the difference between the two...

    Both are measures of percentage change in the the bond price for a given change in the yield.

    What exactly is the difference -- I am sort of tiptoeing on something related to the fact that in one case we are talking about a non-parallel yield shift and the second case a parallel shift in the yield curve.

    Not really sure I grasp the difference between the two measures.

    --sridhar
  2. hi sridar,

    They both assume a parallel shift in yield curve. Effective is a generalized version of modified. Modified is a special (simplified) case of effective which assumes bond cash flows do NOT change when the yield curve is shifted.

    Our FRM examples only require modified duration: price the bond, shock the yield curve in parallel, re-price the bond. If we are dealing with a fixed coupon bond, the coupons here (cash flows) are unchanged just b/c the yield changes. However, if bond has embedded options (that's the rule: if bond has embedded options, generally we say "you need effective duration, modified duration is not up to the job"), the yield curve shift may impact the bond's cash flows, so "effective duration" includes the change on bond cash flows due to the yield curve shift (again, which is unnecessary for plain vanilla bonds)

    In short, modified only changes the yield to get duration. Effective changes yield and, if applicable, bond cash flows, to get duration.

    David

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