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CFA Level I · CFA Level I Exam · Curve-Based and Empirical Fixed-Income Risk Measures

A bond's effective duration is estimated by shifting the benchmark yield curve up and down by the same amount and revaluing the bond. This measure is most appropriate for a bond whose cash flows:

Effective duration is most appropriate for bonds whose cash flows can change when rates change, such as callable bonds. It revalues the bond after shifting the benchmark curve, so it captures option effects that yield-based modified duration, which assumes fixed cash flows, cannot.

  1. Aare fixed and unaffected by interest rates
  2. Bmay change when interest rates change, such as a callable bondCorrect
  3. Care received only at maturity as a single payment

Explanation

Effective duration reprices the bond under curve shifts and so captures changes in expected cash flows, as with embedded options. Modified duration assumes cash flows stay fixed. Option A describes the case where modified duration already works well.

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