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

Effective duration is most appropriate for measuring the interest rate sensitivity of a bond with an embedded option because it:

Effective duration suits bonds with embedded options because it revalues the bond after shifting the benchmark curve, allowing expected cash flows to change as rates move. Yield-based measures such as modified duration assume fixed cash flows, so they misstate the sensitivity of callable or putable bonds.

  1. Auses the bond's yield-to-maturity as the only rate input
  2. Ballows the expected cash flows to change when the benchmark curve shiftsCorrect
  3. Cassumes the bond's cash flows are fixed regardless of the rate level

Explanation

Effective duration is based on full revaluation using a benchmark curve shifted up and down, so the cash flows of an option-embedded bond can change with rates. Yield-based measures such as modified duration assume fixed cash flows, which is wrong for callable or putable bonds.

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