Effective Duration

What Is Effective Duration?

Effective duration is a measure of a security's sensitivity to changes in interest rates. It estimates the percentage change in a bond's price for each one-percentage-point move in interest rates. Unlike simpler measures, effective duration works for bonds whose future cash flows can change when rates move, such as callable bonds, putable bonds, and mortgage-backed securities.

How It Works

Many bonds contain options that let the issuer or the holder change the bond's cash flows. A callable bond, for example, can be repaid early if rates fall. Because of this, a standard calculation based on fixed payment dates and yield can give a misleading answer. Effective duration avoids this problem by measuring the price change directly. Analysts take the bond's price, model how it would change if rates rose and fell by a small amount, and then compare those results.

The formula is:

Effective Duration = (Price if rates fall − Price if rates rise) ÷ (2 × Initial Price × Change in rates)

An Example

Suppose a bond trades at 100. If rates rise by 0.25 percentage points, the model shows a price of 98. If rates fall by 0.25 percentage points, the model shows a price of 102. The difference between the two prices is 4, and dividing by 2 × 100 × 0.0025 gives an effective duration of about 8. This suggests the bond's price would move roughly 8% for a 1-point change in rates.

Why It Matters to Investors

Effective duration helps investors compare how sensitive different bonds are to rate changes, especially bonds with embedded options. Because it depends on a pricing model and assumptions about how the bond's cash flows respond to rates, the result is an estimate, not a fixed number. It can change as rates move. It is often compared with modified duration, which assumes cash flows stay fixed, and with Macaulay duration, which measures the average time to receive a bond's cash flows.