The Concept of Effective Duration

effective duration

The concept of effective duration is a way to evaluate a bond’s price sensitivity to changes in interest rates. It accounts for the uncertainty about the expected cash flow of a bond. Interest rates remain volatile, and the internal rate of return is not well-defined. As a result, strategies based on Macaulay duration are not effective. The following article will discuss the concept and explain how it differs from Macaulay duration.

Modified effective duration

Modified duration is an alternative measure that adjusts Macaulay’s duration to reflect changes in interest rates. It estimates the amount by which a bond’s price will change if interest rates rise or fall by one percent, or by 100 basis points. Modified duration is calculated by dividing the yield to maturity by the number of coupon periods in a year. For example, a bond with a modified duration of 5.3 would increase in price if interest rates fell by one percent.

Macaulay duration

The term “Macaulay duration” is used to describe the amount of time until a bond’s price is repaid. This metric is typically used in bonds but can be applied to other types of securities as well. The Macaulay duration is the weighted average of years a bond would need to pay off its price before it matures. It does not account for changes in interest rates, which affect the cash flow of an optionality bond.

Key rate effective duration

The effective duration of a key rate is the period of time a security’s price would remain unchanged if all other factors were the same. It measures the sensitivity of the security’s price to changes in the key rate at the key nodes of the yield curve. This metric is particularly useful for securities that have embedded options. In practice, key rate duration differs from effective duration. However, the terms are not necessarily mutually exclusive.

Bond’s price sensitivity to changes in interest rate

Modified duration measures the sensitivity of a bond’s price to changes in interest rates. It is calculated by dividing the current bond price by the change in the yield caused by a percentage point increase in interest rates. For example, a bond’s price would decline 5% if interest rates went up by 1%. A bond with a 5-year modified duration would fall by the same percentage.

Bonds with options

The term “effective duration” is a mathematical concept that takes into account the cash flows expected from a bond. The formula uses the Greek letter delta, which stands for “change.” It takes into account the expected decrease or increase in yield to maturity. The formula is equal to the present value of all cash flows from a bond over its entire life, x the change in yield. In other words, the effective duration equals the difference between a bond’s original value and the present value of all of its cash flows.

Bonds with fixed coupon rates

The term effective duration is used to indicate the sensitivity of a bond’s cash flow to changes in the interest rate. Knowing the sensitivity of a bond’s cash flow to changes in the interest rate can help investors make informed investment decisions and protect their portfolios. Effective duration is a key concept in bond analysis. Here are some of the ways that it can be used to evaluate a bond. Listed below are the benefits and disadvantages of effective duration.

Bonds with variable coupon rates

In the bond market, the term “duration” is used to describe the weighted average of the cash flows a bond will make over its life. These cash flows include a series of regular coupon payments and a larger payment at maturity, when the face value of the bond is repaid. In addition, the term “duration” is sometimes used to refer to the duration of an investment.