54 MACAULAY AND MODIFIED DURATIONS 517

54 Macaulay and Modified Durations

By now, it should be clear to you that the timing of cash flows is a significant
factor in the analysis of financial instruments. In this section we develop some
indices to measure the timing of future payments. One index known as
the duration is useful as a measure of the sensitivity of a bonds price to
interest rate movements. The two types of duration we will look at are the
modified duration and the Macaulay duration.
The most basic index of time measuring is the term-to-maturity. For a
given price and par value, among zero coupon bonds, one wishes to purchase
the bond with the earliest redemption time. In the case of bonds carrying
coupons, the redemption time is not enough for helping choose the bond to
purchase.
A better index than the term-to-maturity is the method of equated time,
which was defined in Section 13:
Let R1 , R2 , , Rn be a series of payments made at times 1, 2, , n. Then
the weighted average of the various times of payments, where the weights are
the various amounts paid is
Pn
tRt
t = Pt=1
n .
t=1 Rt

This is also known as the average term-to-maturity.

Example 54.1
Consider two 10-year par value 100 bonds one with 5% coupons and the other
with 10% coupons. Find the equated time for each coupon.

Solution.
The average term to maturity of the 5% bond is
1 5 + 2 5 + + 10 5 + 10 100
t= = 8.50.
5 + 5 + + 5 + 100
The average term to maturity of the 10% bond is
1 10 + 2 10 + + 10 10 + 10 100
t= = 7.75.
10 + 10 + + 10 + 100
This shows that the 5% bond is a longer term bond than the 10% bond
518 MEASURES OF INTEREST RATE SENSITIVITY

An even better index that is similar to the method of equated time is ob-
tained by replacing each payment in the above formula by its present value
thus obtaining Pn
t t Rt
d = Pt=1
n t
.
t=1 Rt

We call d the Macaulay duration or simply duration.

Example 54.2
Suppose payments of 2000, 4000, and 10000 are to be made at times 1, 2,
and 4, respectively. Assume, an annual yield of 25%.
(a) Find the average term to maturity using the method of equated time.
(b) Find the duration of the investment.

Solution.
(a) The method of equated time produces the value
1 2000 + 2 4000 + 4 10000
t= = 3.125.
2000 + 4000 + 10000
(b) The duration is given by

1 (1.25)1 2000 + 2 (1.25)2 4000 + 4 (1.25)4 10000

d= = 2.798
(1.25)1 (2000) + (1.25)2 (4000) + (1.25)4 (10000)

Example 54.3
Consider two bonds purchased at the redemption value of 1000, and due
in 5 years. One bond has 5% annual coupon rate payable semi-annually
and the other has 10% annual coupon rate payable semi-annually. Find the
duration of each bond if both bonds were purchased to yield 7% compounded
semi-annually.

Solution.
The duration of the 5% bond is
0.5[1 (1.035)1 (25) + 2 (1.035)2 (25) + + 10 (1.035)10 (25)] + 5000(1.035)10
d=
(1.035)1 (25) + (1.035)2 (25) + + (1.035)10 (25) + 1000(1.035)10
12.5(Ia)10 0.035 + 5000(1.035)10
=
25a10 0.035 + 1000(1.035)10
=4.4576
54 MACAULAY AND MODIFIED DURATIONS 519

The duration of the 10% bond is

0.5[1 (1.035)1 (50) + 2 (1.035)2 (50) + + 10 (1.035)10 (50)] + 5000(1.035)10
d=
(1.035)1 (50) + (1.035)2 (50) + + (1.035)10 (50) + 1000(1.035)10
=4.1158

Note that d is a function of i. If i = 0 we have d = t so that the method of

equated time is a special case of duration which ignores interest.
Also, note that in the case of only one future payment, duration is the point
in time at which that payment is made. This is clear since the summations in
the numerator and the denominator have only one term each and everything
cancels except the time of payment.

Example 54.4
Find the duration of a 10-year zero coupon bond assuming a yield 8% effec-
tive.

Solution.
Only one payment is involved so that d = 10. Notice that this answer is
independent of the yield rate

Another important fact is that d is a decreasing function of i. To see this, we

have

 Pn
t t Rt

d d t=1
(d) = Pn t
di di t=1 Rt
2
( t=1 Rt ) ( nt=1 t2 t Rt ) ( nt=1 t t Rt )
Pn t P P
= 2
( nt=1 t Rt )
P
"P 2 #
n 2 t
 Pn t
t R t t Rt
= Pt=1n t
Pt=1 n t
t=1 Rt t=1 Rt

Now using Cauchy-Schwartzs inequality

Xn Xn Xn
2 2
( at b t ) ( at )( b2t )
t=1 t=1 t=1

with
520 MEASURES OF INTEREST RATE SENSITIVITY

t 1 t 1
at = 2 Rt2 and bt = t 2 Rt2

we find that Pn 2 t  Pn 2
t
t R t t Rt
Pt=1
n tR
Pt=1
n t
0
t=1 t t=1 Rt

and therefore the derivative of d with respect to i is negative.

We next describe a measure of how rapidly the present value of a series

of future payments changes as the rate of interest changes. Let P (i) denote
the present value of all future payments. Then by Taylor series we can write

 0 2
P (i + ) = P (i) + P (i) + P 00 (i) + .
1! 2!
Using the first two terms we can write

P (i + ) P (i) + P 0 (i).

Hence, the percentage change in P is given by

P (i + ) P (i) P 0 (i)
 .
P (i) P (i)
P 0 (i)
Thus, the percentage change of P (i) is a function of P (i)
. We define the
volatility of the present value by

P 0 (i) d
= = [ln P (i)].
P (i) di

The minus sign is necessary to make positive since P 0 (i) is negative (

increasing the yieldPrate results in a decreasing present value).
Now, = nt=1 (1 + i)t Rt , by taking the derivative we find P 0 (i) =
Pn since P (i)t1
t=1 t(1 + i) Rt . Hence,
Pn Pn
t=1 t(1 + i)t1 Rt 1 t
t=1 t(1 + i) Rt d
= Pn t
= P n t
= = d.
t=1 (1 + i) Rt 1+i t=1 (1 + i) Rt 1+i

Because of this close relationship, volatility is often called modified dura-

tion.
54 MACAULAY AND MODIFIED DURATIONS 521

Remark 54.1
None of the results in this section are valid if the payment amounts vary
depending on the interest rate.

Example 54.5
(a) Find the Macaulay duration of a ten-year, $1,000 face value, 8% annual
coupon bond. Assume an effective annual interest rate of 7%.
(b) Find the modified duration for the bond.

Solution.
(a) We have

80 + 2(80 2 ) + + 10(80 10 ) + 10(1000 10 )

d=
80 + (80 2 ) + + (80 10 ) + (1000 10 )
10
80(Ia)10 0.07 + 100000.07
= 10
80a10 0.07 + 10000.07

But
10
0.07 =(1.07)10 = 0.508349
1 (1.07)10
a10 0.07 = = 7.02358
0.07
1.07a10 0.07 10(1.07)10
(Ia)10 0.07 = = 34.7391
0.07
Hence,
80(34.7392)+10000(0.508349)
d= 80(7.02358)+1000(0.508349)
= 7.3466 years

(b) The modified duration is

= d = (1.07)1 (7.3466) = 6.8660

Example 54.6
A 10-year $100,000 mortgage will be repaid with level semi-annual payments
of interest and principal. Assume that the interest rate on the mortgage is
8%, convertible semiannually, and that payments are made at the end of each
half-year. Find the Macaulay duration of this mortgage.
522 MEASURES OF INTEREST RATE SENSITIVITY

Solution.
Per dollar of mortgage payment, the Macaulay duration is
2 3 20
0.04 + 20.04 + 30.04 + + 200.04
d =0.5 2 3 20
0.04 + 0.04 + 0.04 + + 0.04
0.5(Ia)20 0.04
= = 4.6046 years
a20 0.04
Note that duration depends on the pattern of the level payments and not
their amount
Example 54.7
Find the duration of a preferred stock paying level dividends into perpetuity
assuming effective 8%.
Solution.
Per dollar dividend we have
(Ia) 1.08/.082
d= = = 13.5
a 1/.08
Example 54.8
Find the modified duration for a share of common stock. Assume that the
stock pays annual dividends, with the first dividend of $2 payable 12 months
from now, and that subsequent dividends will grow at an annual rate of 4%.
Assume that the effective annual interest rate is 9%.
Solution.
We have
D1
P (i) =
ig
P (i) = D1 (i g)2
0

P 0 (i) 1 1
v = = = = 20
P (i) ig 0.09 0.04
Example 54.9
You are the actuary for an insurance company. Your companys liabilities
include loss reserves, which are liability reserves set aside to make future
claim payments on policies which the company has already sold. You believe
that these liabilities, totaling $100 million on December 31, 2006, will be
paid out according to the following schedule:
54 MACAULAY AND MODIFIED DURATIONS 523

Proportionl of
Calendar year reserves paid out
2007 40%
2008 30%
2009 20%
2010 10%

Find the modified duration of your companys loss reserves. Assume that the
annual interest rate is 10%, and that all losses paid during a given calendar
year are paid at the mid-point of that calendar year.

Solution.
We have

0.5(4 0.5 ) + 1.5(3 1.5 ) + 2.5(2 2.5 ) + 3.5( 3.5 )

 
= = 1.2796
4 0.5 + 3 1.5 + 2 2.5 + 3.5

Remark 54.2
The equation
P (i + ) P (i)
= 
P (i)
is valid if P (i) stands for the current price of a bond.

Example 54.10
The current price of a bond is $110 and its yield is 7%. The modified duration
is 5. Estimate the price of the bond if its yield falls to 6%.

Solution.
The approximate percentage change in the price is (0.01)(5) = 5%. That
is, the price of the bond increased by approximately 5%. Thus, the new price
of the bond is 110 1.05 = $115.50

Portfolio Modified Duration

Consider a portfolio consisting of n bonds. Let bond k have current price
Pk (i) and modified duration k (i). Then the current value of the portfolio is

P (i) = P1 (i) + P2 (i) + + Pn (i).

524 MEASURES OF INTEREST RATE SENSITIVITY

Let denote the modified duration of the portfolio. Then, we have

P 0 (i) P10 (i) P20 (i) Pn0 (i)
   
= = + + +
P (i) P (i) P (i) P (i)
0 0
Pn0 (i)
     
P1 (i) P1 (i) P2 (i) P2 (i) Pn (i)
= + + +
P (i) P1 (i) P (i) P2 (i) P (i) Pn (i)
P1 (i) P2 (i) Pn (i)
= 1 + 2 + + n
P (i) P (i) P (i)
Thus, the modified duration of a portfolio can be calculated as the weighted
average of the bonds modified durations, using the market values of the
bonds as the weights.

Example 54.11
Megan buys the following bonds:
(I) Bond A with a modified duration of 7 for 1000;
(II) Bond B with a modified duration of 5 for 2000; and
(III) Bond C with a modified duration of 10 for 500.
Calculate the modified duration of the portfolio.

Solution.
The modified duration of the portfolio is weighted average of the modified
durations weighted by the purchase price
7 1000 + 5 2000 + 10 500
= = 6.286
1000 + 2000 + 500
Example 54.12
An investment portfolio consists of two bonds: a two-year zero-coupon bond,
and a four-year zero-coupon bond. Both bonds have redemption values of
$1,000. Assume an effective annual interest rate of 8%. Find the Macaulay
duration of the investment portfolio.

Solution.
The Macaulay duration of the two-year zero-coupon is 2 with current value
1000v 2 . The Macaulay duration of the four-year zero-coupon is 4 with current
value 1000v 4 . The Macaulay duration of the portfolio is
2(1000 2 ) + 4(1000 4 )
d= = 2.9232 years
1000 2 + 1000 4
54 MACAULAY AND MODIFIED DURATIONS 525

Practice Problems
Problem 54.1
Find the modified duration of a 30-year, $1,000 face value, 6% annual coupon
bond. Assume an effective annual interest rate of 9%.

Problem 54.2
Calculate the duration of a payment to be made in 5 years.

Problem 54.3
A 10 year bond has annual coupons of 10 and matures for 100. Which of the
following are true:
(I) The term to maturity is 10 years.
(II) The average term to maturity using the method of equated time is 7.5
years.
(III) The Macaulay duration at 8% interest is 6.97.
(IV) The modified duration at 8% interest is 6.45.

Problem 54.4
Which of the following are true:
(I) The average term to maturity under the method of equated time is always
greater than the volatility.
(II) The duration is a decreasing function of i.
(III) A zero coupon bond will have a Macaulay duration equal to the term
to maturity.

Problem 54.5
(a) Calculate the duration of a 12-year annuity immediate payable using an
interest rate of 5%.
(b) Calculate the modified duration of the annuity.

Problem 54.6
A perpetuity pays 100 immediately. Each subsequent payment is increased
by inflation. Calculate the duration of the perpetuity using 10.25% assuming
that inflation will be 5% annually.

Problem 54.7
Calculate the duration of a perpetuity immediate of 1 less the duration of a
perpetuity due of 1 at an interest rate of 10%.
526 MEASURES OF INTEREST RATE SENSITIVITY

Problem 54.8
Calculate the modified duration of an annuity due with payments of 100 for
10 years using an interest rate of 8%.

Problem 54.9
A bond will pay a coupon of 100 at the end of each of the next three years
and will pay the face value of 1000 at the end of the three-year period. The
bonds duration (Macaulay duration) when valued using an annual effective
interest rate of 20% is X. Calculate X.

Problem 54.10
Suppose that a 3-year financial instrument is expected to make increasing
payments to you at the end of each of the next three years. Specifically,
the payments will be CF (t) = 1, 000t , for t = 1, 2, and 3. Assume that
you purchase this financial instrument, at time 0, at a price which provides
an annual effective yield of 8%. Calculate the Macaulay duration, and the
modified duration of this financial instrument.

Problem 54.11
Calculate the Macaulay duration and the modified duration of a 30-year
zero-coupon bond with a face value of $ 1,000. Assume that the annual
yield-to-maturity is 8%.

Problem 54.12
A 10-year $200,000 mortgage will be paid off with level quarterly amortiza-
tion payments. Assume that the interest rate on the mortgage is 6%, con-
vertible quarterly, and that payments are made at the end of each quarter.
Find the modified duration of this mortgage.

Problem 54.13
Calculate the duration of a common stock that pays dividends at the end of
each year into perpetuity. Assume that the dividend increases by 2% each
year and that the effective rate of interest is 5%.

Problem 54.14
Calculate the duration of a common stock that pays dividends at the end of
each year into perpetuity. Assume that the dividend is constant, and that
the effective rate of interest is 10%.
54 MACAULAY AND MODIFIED DURATIONS 527

Problem 54.15
The current price of an annual coupon bond is 100. The derivative of the
price of the bond with respect to the yield to maturity is 700. The yield
to maturity is an annual effective rate of 8%. Calculate the duration of the
bond.

Problem 54.16
Calculate the Macaulay duration of an eight-year 100 par value bond with
10% annual coupons and an effective rate of interest equal to 8%.

Problem 54.17
John purchased three bonds to form a portfolio as follows:
Bond A has semiannual coupons at 4%, a duration of 21.46 years, and was
purchased for 980.
Bond B is a 15-year bond with a duration of 12.35 years and was purchased
for 1015.
Bond C has a duration of 16.67 years and was purchased for 1000.
Calculate the duration of the portfolio at the time of purchase.

Problem 54.18
A 10-year 1000 face value 6% annual coupon bond with redemption value
C has duration equal to 6.06 using an annual effective interest rate of 6%.
Calculate C.

Problem 54.19
John purchased three bonds to form a portfolio as follows:
Bond A is purchased for X and has a duration of 20 years.
Bond B is purchased for Y and has a duration of 20 years.
Bond C is purchased for X + Y.
The duration (in years) of the portfolio at the time of purchase is 18. Deter-
mine the duration (in years) of Bond C at the time of purchase.