Why is modified duration a bad choice for a callable bond when rates move?
I understand the formula mechanically, but I do not see why the normal duration setup suddenly becomes unreliable once there is an embedded call option.
Modified duration assumes the bond's expected cash flows stay fixed when yields change. A callable bond breaks that assumption.
Suppose Red Harbor Telecom has a callable 9-year bond. If market yields drop, the issuer becomes more likely to refinance. That means investors may receive principal back earlier than originally expected. The bond is not just being discounted at a new rate; its expected cash flow pattern is changing too.
That is why effective duration is the better tool. It captures both:
- the discount-rate effect
- the cash-flow change caused by the embedded option
If the vignette mentions a bond whose future cash flows depend on interest rates, modified duration is usually too simplistic.
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