Effective duration
Price sensitivity measured by revaluing a bond under a shift in rates. It is the only one that works when an option changes the cash flows themselves.
Where you will meet it
Effective duration appears in 9 learning outcomes on the CFA syllabus. A few of them:
- Explain effective duration and the cases that require it
“For a callable, putable or mortgage-backed security, effective duration must be used instead: the price is revalued under a small upward and downward shift of the benchmark curve using a model, and the sensitivity is measured from those two prices.”
- Explain how to measure a bond's sensitivity to each factor that moves the yield curve, and how to use those sensitivities to manage yield curve risk
“Their sum equals effective duration.”
- Assess how a portfolio's rate sensitivity compares with its benchmark's using key rate durations
“A key rate duration measures sensitivity to a shift at one maturity point on the curve, holding the others fixed, and the key rate durations of a portfolio sum approximately to its effective duration.”
- Set out the measures used to gauge risk and return in a bond portfolio and how bonds co-move with other assets
“Effective duration is used when cash flows depend on rates, as with callable bonds or mortgage-backed securities.”
Practise it
Practise effective duration until it is automatic: questions that explain every wrong option.
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