Effective Duration

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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.

BREAKING DOWN '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.

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