When should effective convexity be applied in bond evaluation?

Effective convexity is particularly relevant when evaluating bonds with optionality, such as callable or putable bonds. This concept is important because these types of bonds exhibit non-linear price changes in response to interest rate fluctuations due to the embedded options. Traditional measures of duration may not adequately capture the interest rate risk associated with these options.

For bonds with optionality, effective convexity accounts for the fact that the bond's price will respond differently to changes in interest rates depending on whether the issuer or holder is likely to exercise their option. For example, if interest rates fall, a callable bond may be called away from the investor, limiting its potential price appreciation. Conversely, if interest rates rise, a putable bond may be more attractive to the holder, which can also alter its price dynamics.

This nuanced analysis is why effective convexity should be employed in situations where options are present, as it provides a more accurate measure of risk and price sensitivity reflective of the bond's cash flow characteristics and the embedded options involved.