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. Zero-Gap Condition

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

    A measure of the sensitivity of the price (the value of principal) ...
  3. Modified Duration

    A formula that expresses the measurable change in the value of ...
  4. Fixed-Income Style Box

    Created by Morningstar, a fixed-income style box is designed ...
  5. Empirical Duration

    The calculation of a bond's duration based on historical data. ...
  6. Callable Bond

    A bond that can be redeemed by the issuer prior to its maturity. ...
Related Articles
  1. Do long-term bonds have a greater interest ...
    Investing

    Do long-term bonds have a greater interest ...

  2. Pick the Right Brokerage Account for ...
    Options & Futures

    Pick the Right Brokerage Account for ...

  3. What You Need To Know About Preferred ...
    Trading Strategies

    What You Need To Know About Preferred ...

  4. The Top Technical Indicators For Options ...
    Options & Futures

    The Top Technical Indicators For Options ...

comments powered by Disqus
Hot Definitions
  1. Letter Of Credit

    A letter from a bank guaranteeing that a buyer's payment to a seller will be received on time and for the correct amount. ...
  2. Due Diligence - DD

    1. An investigation or audit of a potential investment. Due diligence serves to confirm all material facts in regards to ...
  3. Certificate Of Deposit - CD

    A savings certificate entitling the bearer to receive interest. A CD bears a maturity date, a specified fixed interest rate ...
  4. Days Sales Of Inventory - DSI

    A financial measure of a company's performance that gives investors an idea of how long it takes a company to turn its inventory ...
  5. Accounts Payable - AP

    An accounting entry that represents an entity's obligation to pay off a short-term debt to its creditors. The accounts payable ...
  6. Ratio Analysis

    Quantitative analysis of information contained in a company’s financial statements. Ratio analysis is based on line items ...
Trading Center