What does Effective Duration represent?

Effective Duration measures the sensitivity of a bond's price to changes in interest rates, taking into account potential changes in cash flows due to embedded options, such as call or put features. It provides a more comprehensive view than Macaulay or modified duration, especially in scenarios where interest rate movements can lead to altered cash flow structures.

The concept of effective duration is particularly relevant for bonds with features that may change the timing or amount of cash flows based on movements in interest rates. For instance, a callable bond may have its cash flows altered if interest rates fall and the issuer decides to call the bond. Standard duration measures may not effectively capture this risk, but effective duration accounts for the expected changes in duration due to shifts in the yield curve.

This characteristic makes effective duration a crucial tool for assessing interest rate risk in a portfolio of bonds that include options. It reflects the dynamic nature of bond cash flows and their price sensitivity, making it a more appropriate measure than simple duration metrics when evaluating bonds with embedded options.