there is this question which mentioned the expensiveness of the tranches. I honestly didnt understand what deffective uration had to do with it. isnt it supposed to be based on option cost only?
I don’t know about that particular problem, but effective duration is one based on bond price which takes into account all options. So, from the binomial tree, you get a particular price taking into account all options…then you assume a higher rate, and recalculate the tree to get the P+ and P- needed for duration. The resulting duration is called effective because it takes these into account. Modified duration is what you normally calculate while ignoring options. My $0.02.
effective duration is also used in those questions to say the following: OAS itself might indicate that a particular tranche is cheap. However, from an investor’s perspective - Duration indicates, on average, when he would recover / recoup the cash flows. Unless he has the capacity to bear the duration (wait out the duration), his cash flow timing needs might be a higher weightage when compared to the “cheapness” of the tranche… so he might instead opt for a more expensive tranche…