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. Modified Duration

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

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

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

    A bond that can be redeemed by the issuer prior to its maturity. ...
  6. Embedded Option

    A provision in a security that is an inseparable part of the ...
Related Articles
  1. Do long-term bonds have a greater interest ...
    Investing

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

  2. How To Buy Oil Options
    Options & Futures

    How To Buy Oil Options

  3. Are Equity-Indexed Annuities Right For ...
    Savings

    Are Equity-Indexed Annuities Right For ...

  4. The Basics of Options Profitability
    Options & Futures

    The Basics of Options Profitability

comments powered by Disqus
Hot Definitions
  1. Elasticity

    A measure of a variable's sensitivity to a change in another variable. In economics, elasticity refers the degree to which ...
  2. Tangible Common Equity - TCE

    A measure of a company's capital, which is used to evaluate a financial institution's ability to deal with potential losses. ...
  3. Yield To Maturity (YTM)

    The rate of return anticipated on a bond if held until the maturity date. YTM is considered a long-term bond yield expressed ...
  4. Net Present Value Of Growth Opportunities - NPVGO

    A calculation of the net present value of all future cash flows involved with an additional acquisition, or potential acquisition. ...
  5. Gresham's Law

    A monetary principle stating that "bad money drives out good." In currency valuation, Gresham's Law states that if a new ...
  6. Limit-On-Open Order - LOO

    A type of limit order to buy or sell shares at the market open if the market price meets the limit condition. This type of ...
Trading Center