Effective Duration

AAA

DEFINITION of '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.

INVESTOPEDIA EXPLAINS 'Effective Duration'

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 was paying a coupon of 6%, the callable bond would behave like an option-free bond because it would not optimal for the company to call the bonds and re-issue them at a higher interest rate.

RELATED TERMS
  1. Bond

    A debt investment in which an investor loans money to an entity ...
  2. Zero-Gap Condition

    When a financial institution's interest rate-sensitive assets ...
  3. Macaulay Duration

    The weighted average term to maturity of the cash flows from ...
  4. Embedded Option

    A provision in a security that is an inseparable part of the ...
  5. Duration

    A measure of the sensitivity of the price (the value of principal) ...
  6. Key Rate Duration

    Holding all other maturities constant, this measures the sensitivity ...
RELATED FAQS
  1. Do long-term bonds have a greater interest rate risk than short-term bonds?

    The answer to this question lies in the fixed income nature of bonds and debentures, often referred to together simply as ... Read Full Answer >>
  2. What options strategies are best suited for investing in the aerospace sector?

    The best options strategies for investing in the aerospace sector exploit the sector's volatility and propensity for big ... Read Full Answer >>
  3. What options strategies are best suited for investing in the Internet sector?

    The long straddle and long strangle options strategies enable investors to capitalize on the Internet sector's volatility. ... Read Full Answer >>
  4. How many attempts at the Series 7 exam are permitted?

    The National Association of Securities Dealers (NASD) has not placed any limits on the number of times you can attempt to ... Read Full Answer >>
  5. Which asset classes are the most risky?

    Equities is the riskiest class of assets. Dividends aside, they offer no guarantees, and investors' money is subject to the ... Read Full Answer >>
  6. Where can I buy covered call ETFs (exchange-traded funds)?

    Covered calls can be traded through any major retail broker. Investors need to have their brokerage accounts approved for ... Read Full Answer >>
Related Articles
  1. Fundamental Analysis

    Explaining the Geometric Mean

    The average of a set of products, the calculation of which is commonly used to determine the performance results of an investment or portfolio.
  2. Mutual Funds & ETFs

    Pros & Cons Of Bond Funds Vs. Bond ETFs

    Understanding the pros and cons of bond funds and bond ETFs will help you choose the instrument that is best for building your diversified bond portfolio.
  3. Mutual Funds & ETFs

    Pros and Cons: Preferred Stock ETFs vs. Bond ETFs

    A look at the differences between preferred stock ETFs and bond ETFs and when you should invest in one over the other.
  4. Options & Futures

    Why Is Best Buy Stock So Volatile?

    We look at why BBY has been so volatile in the past and whether this trend is likely to continue or abate in the future.
  5. Investing Basics

    What is a Stock Option?

    An employee stock option is a right given to an employee to buy a certain number of company stock shares at a certain time and price in the future.
  6. Options & Futures

    Circumvent Limitations of Black-Scholes Model

    Mathematical or quantitative model-based trading continues to gain momentum, despite major failures like the financial crisis of 2008-09, which was attributed to the flawed use of trading models. ...
  7. Retirement

    Don't Make These Top 10 Mistakes On Your Roth IRA

    Don't lose out on the benefits of a Roth by contributing too much, breaking rollover rules or making other avoidable errors.
  8. Trading Strategies

    A Guide Of Option Trading Strategies For Beginners

    Options offer alternative strategies for investors to profit from trading underlying securities, provided the beginner understands the pros and cons.
  9. Trading Systems & Software

    Brokerage Reviews: TradeStation Vs. Interactive Brokers

    These are among the most sophisticated brokers in the industry in terms of investment offerings, market access and technology.
  10. Options & Futures

    How To Lock In Low Oil & Gas Prices

    We provide a quick overview of how companies can manage the risk of adverse moves in commodity prices by hedging in the futures market.

You May Also Like

Hot Definitions
  1. Merger Arbitrage

    A hedge fund strategy in which the stocks of two merging companies are simultaneously bought and sold to create a riskless ...
  2. Market Failure

    An economic term that encompasses a situation where, in any given market, the quantity of a product demanded by consumers ...
  3. Unsystematic Risk

    Company or industry specific risk that is inherent in each investment. The amount of unsystematic risk can be reduced through ...
  4. Security Market Line - SML

    A line that graphs the systematic, or market, risk versus return of the whole market at a certain time and shows all risky ...
  5. Tangible Net Worth

    A measure of the physical worth of a company, which does not include any value derived from intangible assets such as copyrights, ...
  6. Marginal Utility

    The additional satisfaction a consumer gains from consuming one more unit of a good or service. Marginal utility is an important ...
Trading Center