Modified duration is useful and accurate for small changes in yield but it is
not useful and accurate for larger changes in yield.
Fixed Income MCQ - Fixed Income Section 2
Effective duration is used to value bonds with embedded options. This
duration considers changes in a benchmark yield curve and not the bond’s
current YTM.
The modified duration and effective duration of an option free bond are
identical only in the rare circumstance of an absolutely flat yield curve.
- A Effective duration is the appropriate duration measure for a callable bond.
- B The duration of a callable bond is the sensitivity of the bond price to change in the yield-to-worst.
- C A callable bond does not have a well-defined internal rate of return, hence modified and Macaulay duration cannot be used.
The yield to worst is the lowest of the yield to maturity, yield to first
call, yield to second call and so forth. The duration of a callable bond is
not the sensitivity of the bond price to change in the yield-to-worst.
The interest rate risk is the sensitivity of a bond to parallel shifts of the
yield curve. The yield curve risk is a bond’s sensitivity to changes in the
shape of the yield curve.
