Effective Duration

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Definition: Effective Duration

It is a measure where recognition is given to the fact that yield of a fixed income security can change expected cash flows. It is a measure of the price sensitivity of the bond to interest rate changes. Unlike ‘Modified Duration’, it does not assume the cash flows to remain constant. I.e. unlike modified duration, it does not assume that the bond’s expected cash flows will not change when yield changes.

Effective duration is useful to valuate bonds that have embedded options.


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