CFA Practice Question

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CFA Practice Question

What is the relationship between effective duration and modified duration for bonds with embedded options?

I. Effective duration will differ from modified duration because of the changing cash flows.
II. Effective duration will be shorter than modified duration when a bond may be called.
III. Effective duration is affected by changing cash flows while modified duration assumes that the cash flows do not change.
Correct Answer: I, II and III

User Contributed Comments 2

User Comment
01827 why II? I dont understand how effective duration prices embedded options beyond adjusting cash flows to change yield rates...
dbedford Correct me if I'm wrong but I would think that Effective = changing CF with constant rate and Modified = constant CF with changing rates; therefore, Effective will be be shorter than Modified when a bond is called because a called bond has a shorter duration than the modified's fixed duration.
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