
Explanation:
We first calculate the present value of cash flows as follows,
P = 80/(1.06^1) + 80/(1.06^2) + 1080/(1.06^3) = 1,053.46
The Macaulay duration is given by,
Macaulay Duration = Σ t_i × [PV(C_t) / Σ PV(C_t)] = [80/(1.06^1)/1,053.46] × 1 + [80/(1.06^2)/1,053.46] × 2 + [1080/(1.06^3)/1,053.46] × 3 = 2.7891
And thus, the modified duration is given by
Modified Duration = 2.7891 / 1.06 = 2.6312
Modified duration is derived from Macaulay duration and measures the price sensitivity of a bond to changes in yield. It is calculated as Macaulay Duration divided by (1 + yield per period).
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