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Up0
I’m looking at CFAI’s explanation of why ModDur is the way to go for bonds with embedded options, and it’s not getting through. How would you explain this to a 10-year old?
Thanks.
-Bob -
Up5
Yes, it did answer the question. The reason why I’m not able to see why ModDur is the way to go for embedded options is because ModDur is not the way to go for embedded options.
#winningtheeasyway
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Up4
Hey @BobBarkerPlaysPlinko‌, you may have got it the other way round. Modified duration is only suitable for option-free bond as Modified Duration assumes that changes in yield of a bond does not affect its cash flow. That is not true for a bond with embedded options, e.g. callable bond.
Effective duration on the other hand is the change in bond Price due to a 1% Change in interest rates, that also takes into account the impact of changing interest rates to the bond’s cash flow (and hence price).
In other words, for a striaghforward bond without embedded options, modified duration should be equal to effective duration.
Hope this helps
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