Financial Dictionary
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 Commentary
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 were paying a coupon of 6%, the callable bond would behave like an option-free bond since it is not optimal for the company to call the bonds and reissue bonds at a higher interest rate.
Related Links
Advanced Bond Concepts
See also: Bond, Callable Bond, Duration, Embedded Option, Macaulay Duration, Modified Duration
