Question

Is modified duration a good estimate for the percentage price change for mortgage securities? Why? How can it be improved?

Answer 1

Yes Modified Duration is a good estimate for the percentage price changes for mortgage securities. Modified Duration is a measure used to indicate the change in the value of the security in response to the interest rate changes. It considers how the price of a bond changes in response to yield changes. There is an inverse relationship between the price of the bond and the interest rates, which means an increase in interest rate would decrease the value of the bond and viceversa. But the identification and calculation of the bond duration is very important for investors as it helps them to compare bonds with different issues , maturity dates and coupon rates. Modified Duration is also interpreted as the percentage change in a price for mortgage securities for a small change in its yield to maturity. The best interpretation of the duration is approximate percentage price changes for a 1% change in yield to maturity.

Inorder to improve modified Duration, as there is an inverse relatioship between the price of the mortgage securities and interest rate , if we are reducing the interest of the securities the value of the securities will increase and modified duration will automatically improve. Thus through increasing the interest rate will increase the bond value and would definetly improve the modified duration.