basic question; what’s the difference between effective duration and modified duration? in the exam, both are same meaning? thanks in advance.
Mod. duration expresses the measurable change in the value of a security in response to a change in interest rates. (similar to duration) Effective duration is basically a duration calculation for bonds with embedded options (this is key)
my 2 cents on this as I understand it Modified Duration is considered a static duration measure, calc’d from cash flows. Effective duration is a measure that considers the embedded options by considering the price sensitivity to an incremental increase and decrease in interest rates.
Macauley duration is static. It is calculated by taking the weighted average of an instruments cash flows and does not consider that duration changes with the price of an instrument. Modified duration is a better measure for bonds that do not have imbedded options than Macauley because it factors in that duration is sensitive to changes in interest rates. Effective duration is calculated using binomial interest rate trees and finding the OAS of the bond. Effective duration is also known as OAS duration. This is the best measure for bonds with imbedded options.