Page 13 - FINAL CFA SLIDES DECEMBER 2018 DAY 15

Effective Duration (EffDur), p.106 Session Unit 16:
54. Understanding Fixed Income Risk and Return

This applies to bonds with embedded options as the future cash flows and timing are contingent on exercise
unlike other bonds where the future cash flows and timing are known with certainty (hence we simply use
the bond prices and YTM provided).

For example, mortgage-backed bonds have a prepayment option -similar to a call option on a corporate bond.
The borrowers have the option to pay off the principal, in whole or in part, at any time. These accelerate when

interest rates fall because borrowers can refinance their home loans and pay off the remaining principal owed
on an existing loan.

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Thus, the pricing of such a bond begins with the benchmark yield curve, not simply the current YTM. The
appropriate measure of interest rate sensitivity for these bonds is effective duration.

Key differences with other methods of calculating Duration?

1. The effects of changes in benchmark yields and changes in the yield spread for credit and liquidity
risk are separated:
• ModDur makes no distinction between changes in the benchmark yield and changes in the spread.
• Effective duration reflects only the sensitivity of the bond’s value to changes in the benchmark

yield curve. Changes in the credit spread are addressed with a separate “credit duration” measure.

2. Unlike ModDur, EffDur does not provide better estimates of bond prices for smaller changes in yield. It
may be the case that larger changes in yield produce more predictable prepayments or calls than small

changes