A.6.

2 Part 2: Effective Duration

by Lee Gibson, Ph.D.

c 2012 The Infinite Actuary, LLC

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https://www.desmos.com/calculator/nhede03qd7

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A.6 Cashflow Duration
A.6.2 Part 2: Effective Duration
Review: Price and Duration of a Coupon Bond
Review: Price of a Callable Coupon Bond
Effective Duration
Properties of EffD
Exercise 1
Exercise 2

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Price and Duration of a Coupon Bond

How does the price of a bond change as a function of the yield?
Suppose that a bond pays annual coupons at a rate of 6% and
comes to maturity at the end of 12 years.
With redemption value 1,

P pyq “ 0.06a12 :y ` p1 ` yq´12 .

Remember

MacD “ a
:12 :0.06 “ 8.88687, and
ModD “ MacD{p1 ` yq “ 8.383844.

Or,
P 1 pyq
ModD “ ´
P pyq
P 1 pyq–Yuck! Use WolframAlpha.
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Price of a Callable Bond
If the bond is callable at or after the 6th coupon
and the interest rate drops,
there will only be 6 payments before the bond is called, so the
price function will change to:

P pyq “ 0.06a6 :y ` p1 ` yq´6 when y ă 0.06.

P pyq breaks into two pieces.

In our example,
P p0.07q´P p0.05q
2p0.01q
EffD “ ´
P p0.06q
0.92057´1.05076
0.02
“´ “ 6.5092
1

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Effective Duration

Definition: The Effective Duration at yield rate y0 with

change in yield rate h is:
two-sided diff. quotient using ∆y “ h
EffDh py0 q “ ´
Original Price at yield rate y0
P py0 `hq´P py0 ´hq
2h
“´ .
P py0 q

Compare this to

P 1 py0 q
ModDpy0 q “ ´
P py0 q

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Things to Notice

If Cash Flows do not depend on the interest rate,

EffD « ModD.
Check this for the non-callable bond.
P p0.07q´P p0.05q
2p0.01q
EffD “ ´ “ 8.40
P p0.06q

Recall:
P 1 p0.06q
ModD “ ´ “ 8.38
P p0.06q

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More Things to Notice

EffD depends on the size of h!

To compute EffD, you must be told what value of h to use.

If the asset has cash flows that depend on the yield rate
Ñ You must be told the prices, or
Ñ You must already know how to calculate the prices.

It is VERY UNLIKELY that Effective duration will be on your

exam.
Included here to provide complete coverage of the eligible topics.
NOT because we think it is likely to appear on the exam.

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Exercise 1
For a certain asset, if the yield rates move up or down by 50
basis points, then the price of the asset will move either down
by $0.22 or up by $0.41, respectively. Compute EffD ˆ P py0 q,
where P py0 q is the price of the asset with the original yield rate.

P py0 ` 0.005q “ P py0 q ´ 0.22

P py0 ´ 0.005q “ P py0 q ` 0.41

P py0 ` 0.005q ´ P py0 ´ 0.005q

EffD0.005 py0 q ˆ P py0 q “ ´
2p0.005q
´0.22 ´ 0.41
“´ “ 63.
0.01

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Exercise 2

For a certain asset, the Effective duration has been found to be

8.4. Approximate the percentage change in the price of the
asset if the yield rate increase by 25 basis points.

Use EffD the same way that you would use ModD.

%∆P “ ´ EffD ˆ ∆y “ ´8.4 ˆ 0.0025 “ ´0.021

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