What does the term "effective duration" refer to in bond valuation?

Effective duration is a measure specifically designed to assess the sensitivity of a bond's price to changes in interest rates, taking into account the potential variability in cash flows due to embedded options such as calls or puts. This is particularly important for bonds with options, as their cash flows can change based on movements in interest rates. The effective duration provides a more accurate reflection of interest rate risk for these instruments compared to traditional measures of duration, which do not account for changes in cash flows.

By considering how market interest rates impact the expected cash flows, effective duration gives investors a clearer understanding of how a bond's price may react to interest rate changes. This makes it a crucial tool for assessing the interest rate risk associated with bonds, especially in a portfolio context where cash flows may not remain fixed.

The other options don't capture this essence of effective duration. Some refer to calculations or methodologies that do not account for the dynamic nature of cash flows in bonds. Therefore, recognizing effective duration as a measure that includes adjustments for interest rate changes is central to understanding its role in bond valuation.