ECONOMICS (CBSE/UGC NET)

Detailed explanation-1: -Bonds with an embedded option do not have a meaningful internal rate of return because future cash flows are contingent on interest rates. Therefore, effective duration is the appropriate interest rate risk measure, not modified duration.

Detailed explanation-2: -Effective Duration Effective duration is a measure of the duration for bonds with embedded options (e.g., callable bonds). Unlike the modified duration and Macaulay duration, effective duration considers fluctuations in the bond’s price movements relative to the changes in the bond’s yield to maturity (YTM).

Detailed explanation-3: -Duration is a measurement of a bond’s interest rate risk that considers a bond’s maturity, yield, coupon and call features. These many factors are calculated into one number that measures how sensitive a bond’s value may be to interest rate changes.

Detailed explanation-4: -The correct answer is B. Effective duration is essential for the measurement of interest rate risk for complex bonds such as bonds with embedded call, put or convertible options but also for mortgage-backed securities.