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Basic Question 8 of 24
What is the relationship between effective duration and modified duration for bonds with embedded options?
II. Effective duration will be shorter than modified duration when a bond may be called.
III. Effective duration is affected by changing cash flows while modified duration assumes that the cash flows do not change.
I. Effective duration will differ from modified duration because of the changing cash flows.
II. Effective duration will be shorter than modified duration when a bond may be called.
III. Effective duration is affected by changing cash flows while modified duration assumes that the cash flows do not change.
User Contributed Comments 2
| User | Comment |
|---|---|
| 01827 | why II? I dont understand how effective duration prices embedded options beyond adjusting cash flows to change yield rates... |
| dbedford | Correct me if I'm wrong but I would think that Effective = changing CF with constant rate and Modified = constant CF with changing rates; therefore, Effective will be be shorter than Modified when a bond is called because a called bond has a shorter duration than the modified's fixed duration. |
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Barnes
Learning Outcome Statements
explain why effective duration and effective convexity are the most appropriate measures of interest rate risk for bonds with embedded options
calculate the percentage price change of a bond for a specified change in benchmark yield, given the bond's effective duration and convexity
CFA® 2025 Level I Curriculum, Volume 4, Module 13.