Effective term is a metric used to estimate investment return, considering changes in interest rates. It’s important for investments that issue periodic yields. Accuracy depends on data quality and projections.
Effective term is a type of metric used to estimate the amount of return on an investment, taking into account possible changes in the interest rate that applies to the investment. Also known as empirical duration, the base duration formula is often used with bonds and similar investments where a variable or variable interest rate applies. While there are other means of calculating the return on an investment that does not have a fixed interest rate, actual term is considered to be among the most reliable.
Calculating effective maturity is especially important if the investment is likely to issue a portion of the yield periodically throughout the life of the bond. By defining the term in terms of time from the last disbursement to the date the next payment will be issued, it is possible to project what will happen with the prevailing interest rate in the meantime. Accurately calculating this figure helps the investor have a good idea of what kind of return to expect for the period and how that return will affect cash flow.
In most cases, the actual duration is expressed in years. This is because most investments that offer an interest rate-based return pay for themselves at maturity or every few years over the life of the security. When trying to determine the cumulative effective life of an investment from the point of purchase to the day maturity is reached, it is sometimes helpful to consider each period in which a payment is calculated and issued. When no return is expected until the investment reaches maturity, the entire life of the security is considered as part of the calculation.
As with any tool used to project return on an investment, the actual duration is only as good as the information used for the calculations. For this reason, special attention should be paid to compiling the data that will be used in the calculation process. Any inaccuracy could cause significant projection misalignment. For example, if the projections of interest rate changes over the period prove to be inaccurate, the actual duration results will not occur. For this reason, investors should be aware of any unexpected changes in interest rates and be prepared to recalculate the effective term as and when such changes become apparent.
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