Effective Duration

Effective Duration

A duration calculation for bonds with embedded options. Effective duration takes into account that expected cash flows will fluctuate as interest rates change.

Notes:

Effective duration can be estimated using modified duration if the bond with embedded options behaves like an option-free bond. This behavior occurs when exercise of the embedded option would offer the investor no benefit. As such, the security's cash flows cannot be expected to change given a change in yield.

For example, if existing interest rates were 10% and a callable bond were paying a coupon of 6%, the callable bond would behave like an option-free bond since it is not optimal for the company to call the bonds and reissue bonds at a higher interest rate.

See also: Bond, Callable Bond, Duration, Embedded Option, Macaulay Duration, Modified Duration

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Effective duration

The duration calculated using the approximate duration formula for a bond with an embedded option, reflecting the expected change in the cash flow caused by the option. Measures the responsiveness of a bond's price - taking into account that expected cash flows will change as interest rates change due to the embedded option.