Why is effective duration better than modified duration for bonds with embedded options?

Modified duration assumes the bond's cash flows stay fixed when yield changes. That is the wrong assumption when the option can alter expected maturity or expected payments.

Effective duration estimates sensitivity by comparing model prices after an up-rate and down-rate move. Those model prices can incorporate the chance that a callable bond is redeemed or that a putable bond is sold back to the issuer.

Use this exam habit:

• Fixed cash flows and small yield change: modified duration can work.
• Cash flows may change with rates: effective duration is the safer answer.
• Nonparallel curve exposure: consider key rate duration.