Effective Duration

Effective duration is a measure of the sensitivity of a bond or derivative price to changes in benchmark interest rates, specifically accounting for embedded options. Unlike modified duration, which assumes cash flows remain constant, effective duration incorporates the impact of interest rate changes on the timing of cash flows.

This is essential for instruments exhibiting negative convexity, as the price-yield relationship is not linear. By modeling how the asset price changes given a parallel shift in the yield curve, practitioners can quantify the interest rate risk more accurately.

It serves as a primary metric for portfolio managers to hedge against volatility and ensure the portfolio duration aligns with risk mandates.