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. Empirical Duration

    The calculation of a bond's duration based on historical data. ...
  4. Modified Duration

    A formula that expresses the measurable change in the value of ...
  5. Callable Bond

    A bond that can be redeemed by the issuer prior to its maturity. ...
  6. Fixed-Income Style Box

    Created by Morningstar, a fixed-income style box is designed ...
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 is the difference between in the money and out of the money?

    In options trading, the difference between "in the money" and "out of the money" is a matter of the strike price's position ... Read Full Answer >>
  3. If a long call is owned on the record date of a stock, is the owner of the option ...

    The owner of a long call for a stock is entitled to a dividend only if the option is exercised prior to the ex-dividend date, ... Read Full Answer >>
  4. How can an investor profit from the cyclical nature of the electronics sector?

    An investor can profit from the cyclical nature of the electronics sector in two ways. He can employ sector rotation, shifting ... Read Full Answer >>
  5. What does negative vega mean for credit spreads?

    Greek vega measures an option's sensitivity with respect to a change in the underlying asset's volatility. The vega of an ... Read Full Answer >>
  6. What options strategies are best suited for investing in the banking sector?

    The covered call option strategy allows investors to profit from the banking sector's stability and its track record for ... Read Full Answer >>
Related Articles
  1. Investing Basics

    What is a "Coupon"?

    In the financial world, “coupon” represents the interest rate on a bond.
  2. Options & Futures

    SEC-Regulated Options Brokers

    Investopedia provides a List Of SEC-Regulated Options Brokers
  3. Stock Analysis

    Is it Time to Buy Floating Rate Bonds?

    The Fed’s awaited interest rate hike could finally be at hand. Are floating rate bonds the way to go?
  4. Investing Basics

    Treasury Inflation-Protected Securities (TIPS)

    Treasury inflation-protected securities are treasury securities that make adjustments for inflation as reflected in the Consumer Price Index.
  5. Retirement

    Facing Retirement? Look Beyond 100% Bonds

    Retiring doesn't mean putting all your money in bonds. There are two things to consider when it comes to be invested in bonds: growth and inflation.
  6. Mutual Funds & ETFs

    Is the PowerShares (PFEM) ETF a Good Bet Now?

    What you need to know if you are considering trading PowerShares Fundamental Emerging Markets Local Debt ETF.
  7. Mutual Funds & ETFs

    Anatomy of Emerging Markets Debt ETF (EMLC)

    This emerging market bond ETF offers a high yield, but there are dangers. Find out why.
  8. Trading Strategies

    How to Pick the Best Dividend Stocks

    Dividend stocks can make you rich, but you have to be patient.
  9. Options & Futures

    How To Trade Orange Juice Options

    How do orange juice options work and which factors determine the orange juice valuations? Here's a sneak peak into the world of orange juice options.
  10. Trading Strategies

    4 Quality Dividend Stocks You Need to Consider

    Looking for quality stocks that also pay dividends? Consider these four.

You May Also Like

Hot Definitions
  1. Geometric Mean

    The average of a set of products, the calculation of which is commonly used to determine the performance results of an investment ...
  2. Fisher Effect

    An economic theory proposed by economist Irving Fisher that describes the relationship between inflation and both real and ...
  3. Fiduciary

    1. A person legally appointed and authorized to hold assets in trust for another person. The fiduciary manages the assets ...
  4. Expected Return

    The amount one would anticipate receiving on an investment that has various known or expected rates of return. For example, ...
  5. Carrying Value

    An accounting measure of value, where the value of an asset or a company is based on the figures in the company's balance ...
  6. Capital Account

    A national account that shows the net change in asset ownership for a nation. The capital account is the net result of public ...
Trading Center