Effective duration is the calculation of the duration of bonds that have embedded options. This type of calculation takes into consideration the fluctuation of expected cash flows as the interest rate changes. Embedded options are financial bonds that provide the issuer the right to take action against the holder or vice versa. Embedded options are commonly found in callable bonds, exchangeable bonds, and puttable bonds.
Some people assume that effective and modified duration are calculated in the same manner. However, this assumption is incorrect. First of all, both types are considered to be the ratio between the bondss proportional change and the spot yield curves parallel shift. They are used as methods to estimate the changes in bond prices as well as to assess the volatility of prices instantly. To assess the real value of a bond, such as those invested in international bond mutual funds, the investor has to calculate durations using a certain formula.
While the two are seemingly the same in many ways, modified duration is used only for bullet securities with a fixed rate. The formula used in the calculation is not appropriate for bond funds where a change in interest rate also cause a change in cash flow. Therefore, the value of step-ups, mortgage-backed securities, floaters and callables should be estimated using a different formula, hence the effective duration.
The sensitivity of such funds to interest rate fluctuations calls for a specific calculation that involves this factor. When a funds duration is longer, it tends to be more sensitive towards the fluctuations in interest rates. Therefore, a fund with a ten-year duration is considered to be two times more volatile than one with a duration of five years. This direct relation allows investors to easily calculate the rise and fall of the value of bonds with embedded options.